Engaging in active vs. passive investing

By Christopher Raby The Daily Record Newswire When investors make decisions about where and how they invest their money, they also need to make a decision as to what sort of investment strategy they will use. Passive investing is a strategy based on the diversification of investments over a certain time period and risk horizon. Active investing uses formulated techniques and strategies in an attempt to beat the overall market and earn a return in excess of the whole market. While both strategies can be successful, they each have their own benefits and downfalls in the long run. The primary argument for passive investing is that the stock market is essentially efficient. This means that the overall market has already priced securities to their fair market value. Because of that, fundamental analysis as well as technical analysis cannot be used to successfully beat the market in the long run. According to this argument, investors should buy index funds, accept the market return, and attempt to minimize their expenses. Passive investing can be immensely successful in wealth creation. The addition of several index funds to one's own saving strategy can provide a solid base to generate long-term returns. Investing just $100 a month in a portfolio averaging an 8 percent return per year will grow into a $150,000 balance after 30 years. This strategy can be simply implemented, as many fund companies offer automatic reinvestment plans once the initial investment is established. Also, education into aspects of technical and fundamental analysis is not needed, since one is merely using index funds as an investment vehicle. Lastly, a buy-and-hold investment style will successfully defer taxes to later periods of time. The primary obstacle to passive investments is that the time period to generate significant returns is often very long. This dissuades many investors who see the market return as minimal and feel they can earn better by actively investing by themselves. To successfully build a portfolio based on passive investment, one must select index funds that are diverse in their asset classes. Additionally, a portfolio should also be created towards one's own risk tolerance and time horizon. Younger investors who have a longer time horizon and high risk tolerance can afford riskier investments. Older investors, with a shorter time horizon and fixed income needs can place investments in bond funds. Active investing proponents suggest the ability to beat the market and earn above average returns. They often suggest that the market is inefficient on all levels and both technical and fundamental analysis can be used to successfully earn returns superior to index funds. The major drawback to active investing is the vast amount of knowledge required to learn all of the techniques. A wide majority of people simply do not have an interest in developing the required knowledge. Additionally, in order to be a successful active investor, trading experience is typically helpful. To identify technically or fundamentally optimal points of entry into a stock, one must have had the prior experience necessary to identify such a point. Lastly, active investing can involve significant costs. These costs occur from trading costs and the possibility of the investor facing short-term capital gains taxes if he/she trades too frequently. These three drawbacks provide a barrier to entry to active investing for many individual investors. Considering the drawbacks, it seems like active investing may be difficult to implement for many investors. In fact, many investors that stylize themselves as active often earn less than the return from passive investments. Very few investors consistently beat the market over the long-term. Overall, selection of an investment strategy depends largely on an investor's discipline and goals. To be successful with an active investment style, a great deal of effort is required. Often times, this is largely best left to investment professionals to minimize turnover and maximize investment selection and performance. Passive investment can be done by anyone, but at the sacrifice of market-beating returns. All-in-all, choice of investment styles -- and the success that results from them -- depend largely on the individual investor. ---------- Christopher Raby is an analyst/portfolio manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680. Published: Thu, Jul 19, 2012