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Understanding the difference between Passive and Active Investing

I have been blessed to be happily married to my beautiful wife Christa for almost 39 years.  I’ve been equally blessed with a wonderful mother-in-law and father-in-law.  I was truly honored when they asked me to be their financial advisor back in 2009 (I guess they figured Christa and I would make it -lol).  When I first reviewed their portfolio, I was amazed at their stock portfolio.  Much of it was inherited by my mother-in-law at her father’s death which has been well over 35 years ago.  He and his wife had developed the portfolio a stock at a time over many years.  The list of companies represented was a who’s who of some of the most respected companies in the country.  Although the portfolio has seen change with stock splits, change of names of companies, mergers, etc… basically the portfolio mix of stocks have remained the same.  Over the 60 years or more the portfolio was accumulated, it has grown substantially.  I share this story as it is a real-life example of what “Passive” Investing looks like utilizing the tried-and-true investing philosophy of “buy and hold”

However, as I reviewed the part of their portfolio that they had accumulated or invested in since 2000, it looked drastically different.  When I met with them in 2009, we discovered that the bulk of their portfolio had experienced a net gain of 0% over the past decade. During that period, they saw the stock market enter a severe bear market from 2000-2002 due to the dot.com bubble busting, 9/11, and the resulting deep recession.  The S&P 500 declined over 46% during that time from it’s highs in 1999.  Then about 2003 their portfolio began to grow again and was even in the positive and then the 2008 financial crisis occurred.  In 2008 alone the S&P 500 dropped over 38%.  Here we were in 2009 evaluating what many have dubbed, “The Lost Decade” when it comes to investing.  The same passive “buy and hold” strategy that had worked so well for decades in their stock portfolio had not worked as well the first decade of the Century.  I remember telling them at the time somewhat in jest (but totally serious), that “It’s not your father’s stock Market”.

Because of the “lost” decade, many investors began to realize that possibly there needed to be strategies available that require more of a hands-on approach to investing to deal with the new century of investing.  So many new strategies were developed by the financial industry that we now call “Active Investing”.  So let’s define each a little more clearly:

Passive Investing:

Passive investing is simply the strategy of buying and holding investments such as stocks, bonds, and alternatives for a long period of time.  It accepts the ups and downs of the market as normal and as long as you wait long enough there will be more then you started with.  This may be accomplished by investing in individual stocks or bonds, or through a collection of Mutual Funds or in more recent years Exchange Traded Funds (ETFs).  Many people believe the act of buying Mutual funds or ETF’s is “Active” investing.  But the truth is, Most Mutual Funds and ETFs are by their very nature “buy and hold” strategies in order to keep fees low with little turnover in the portfolio.  So, in essence it is buy and hold by the investor in the fund and buy and hold by the investment company in the actual holdings inside the mutual fund or ETF.

Active Investing:

Active investing is a strategy that involves frequent trading to accomplish its goals.  Commonly, active investing will have a primary focus of Risk Management (minimizing risk), Growth Management (maximizing growth to possibly meet or beat the S&P 500), or a combination of both.  There are a variety of strategies utilized in active investing including but not limited to:  Economic Trending, Market Momentum, Hedging, Rebalancing, Technical analysis, and a host of other nuanced strategies that have been created.

Both Passive and Active investing have advantages and disadvantages.  Let’s take a look at a few of each:

Advantages of Passive Investing:

* Lower cost investing due to lack of active management and infrequent trades

* Transparency – It’s easier to understand what you own since it rarely changes

* Possibly higher returns in up markets – this is due to the lack of risk management

Disadvantages of Passive Investing:

*No exit strategy in severe bear markets

*Likely to take longer to recover from a bear market due to its lack of exit strategy

*Usually provide less diversification than a managed portfolio as it is focused on individual funds or strategies.

Generally speaking, passive investing is more appropriate for the investor who wants to manage their own funds, is more concerned about fee exposure then managing risk and growth, who has owned particular holdings for a long period of time (like my in-law’s stock portfolio) since the capital gains are so high, and for investors whose only goal is growth and wants the simplest way to approach investing.

Now let’s look at Active Investing:

Advantages of Active Investing:

*Flexibility in volatile market – can reallocate to asset classes that have the greater momentum and possibly lessen catastrophic risk when a defensive position is taken.

*More investment options – active management opens the larger world of investing.  This has become easier to accomplish with the creation of Exchange Traded Funds and unified management accounts.

*Greater support available – many active investing strategies are offered through financial advisors.  This gives the active investor access to greater educational materials, more hands-on approach, and someone to work side by side within volatile markets.

* Potential Tax Efficiency – active management allows trades to be made in a more tax efficient way by liquidating under performing investments to help offset gain of higher performers.

Disadvantages of Active Investing:

*Higher expenses – Management fees are generally higher than self-managing buy and hold positions.  Active management may contain an advisor, money manager, and record keeper.  All will receive some form of compensation.

*Complexity – Active management strategies by their very nature are more complex then simply buying a stock and holding it.  It is often necessary to put your educated trust in the financial advisor as you get a better understanding of how the active management strategy works.

*Trend Exposure – It is possible that an active management approach can get on the wrong side of the current trends.  It is necessary to not only use active strategies but to actively monitor the strategies and make adjustments to lessen this risk.

Active investing is more appropriate for the investor who would like the potential to avoid catastrophic losses or would like greater diversification then they can find on their own.  It is also at times appropriate for people who simply don’t want to manage their money themselves.

So, what’s the bottom line:

I’m pleased to say that my in-laws experience utilizing my Four Cornerstone Planning Process dramatically improved their situation since 2009.  Even in the midst of volatility that has been created from an immigration crisis in Europe, fear of trade wars, and of course most recently the Covid crisis, their portfolio has experienced stable growth and minimized risk of catastrophic loss.

This was accomplished by using a combination of Active and Passive Strategies.  I believe that it isn’t a matter of which is best but more of a matter of which is in YOUR best interest.  For many people it is a portfolio designed with both passive and active strategies to provide the greatest potential to meet your needs, goals, and dreams in retirement.

If you would like to see a simple tool that I utilize in my Four Cornerstone Planning Process called my Four Cornerstone Allocation Model, simply give us a call at (865)288-7685 or go to my home page at www.stiversfinancial.com and click on the schedule appointment button which will give you access to my calendar to schedule a time convenient for you.

Investing involves risk and investors may incur a profit or a loss. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Investors should carefully consider the investment objectives, risks, charges and expenses of mutual funds and exchange-traded funds (“ETF”) before investingShares of ETFs are bought and sold at market price (not NAV) and are not individually redeemed from the fund.

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