If you want to arouse a fiery debate in a crowd of people interested in the topic of investment management, a sure bet is to start discussing the relative merits of active investment management versus passive investing management styles. Both have their points and relative merits advocates.
The passive style of investing advocates present their case by stating that the markets are efficient. In other words, the vast majority of information that can be known is already in the market place and therefore there is no advantage to spending effort in researching stocks because there is little that is unknown about their prospects. In addition, passive proponents argue that the lower costs of index funds and ETFs provide a lower hurdle to overcome with respects to returns rather than their active counterparts. An additional advantage is that the turnover is very low in index funds or ETFs and results in lower tax costs for taxable accounts. Further they will argue that 80% of the active managers will underperform a relative index.
The active investing side of the argument argues that there is a difference between companies. Some are more reasonably valued and have better growth prospects. Selecting higher quality companies leads to better results over time. While true that 80% underperform, this is also true in other endeavors. For example, only 20% of professional athletes are viewed to be truly exceptional in their sport while all are exceptional compared to the vast majority of us. In their universe of comparison, not all are superstars. The challenge is to find the 20% that do outperform and do so consistently. The Pareto principle, attributed to Economist Vilfredo Pareto, stated his premise by first observing that 20% of the effort resulted in 80% of the value. The Pareto Principle is observed in virtually all endeavors and processes so to find it within investing comes as no surprise.
Clearly active investment management is not for the investor who wants to pick a few funds and ignore the portfolio. Passive investing is by far the simplest approach. Those seeking the benefits of the 20% producing the higher results will need to establish solid processes and screens to achieve those results. One must see that an active investing approach must outperform after fees and expenses to be of any benefit.
Some questions for those seeking financial advisors include:
- What process(es) do you use in selecting investments?
- What are your selection criteria in screening investment managers?
- How do taxes, fees and expenses play in your decision-making?
Finding the right approach may not be found on the extremes of the debate, but somewhere in the middle as with many things in life. An approach that mixes the best of both worlds may strike the perfect balance. One thing is for sure – the debate will rage on for a few more decades.
Share your views – Which side of the debate are you on?
To learn more about Bob Kosterman, view his Paladin Registry profile.
Other posts from Bob Klosterman
While I never have seen a survey inquiring about the desire for investing at the perfect time, I...
It’s sooooo NOISY out there! People don’t have a good intuitive sense of how to weigh new information in...
Many of the comments we received from clients, friends and acquaintances express frustration with the current economic and...