Hey internet, Daniel here from Next Level Life and today we’re going to be talking
about the differences between passive and active investing as well as exploring how
much of a difference this one choice can make on your net worth by the time retirement rolls
around.
So what is passive investing?
Passive investing is an investing strategy where the investor adopts a buy and hold strategy
as opposed to making regular trades.
Often times when people talk about passive investing they are actually talking about
index investing.
And index investing is exactly what it sounds like it's where you pick one of the indices
to track and you basically have gain when the market goes up and take losses when the
market goes down.
It’s pretty simple.
Common indices that are tracked would be the S&P 500 or the Dow Jones Industrial Average
though there are several others.
And the nice thing about index investing is it's usually very cost effective in comparison
to active investing, because the fund does not have to pay a manager to analyze what's
going on in the market and and have him or her trying and figure out which stocks are
going to have the biggest gains and which ones should be sold every single day.
Because again the goal of index investing is to just match the market over the Long
Haul.
Active investing on the other hand takes a Hands-On that requires someone to act in the
role of portfolio manager, again trying to find a way to beat the market by taking full
advantage of short-term stock price changes.
This can work out very well for example when apple dropped down to less than $60 a share
in 2013, portfolio managers were able to take advantage of that and now Apple sits at around
$150 a share as of this recording.
That means that over the course of a few years someone who had invested an Apple at $60 a
share would have more than doubled their money.
Of course it can also go the other way with a stock being picked up when it's at a high
point because the manager thinks it's going to continue to go up but then it ends up going
down and the investor loses money.
So active investing requires confidence that whoever is managing the portfolio will know
exactly when the right time to buy and sell is and it requires them to be right more than
wrong.
But of course the big question is which one makes you more money?
Now you'd think that a professional manager's capabilities would trump that of a basic Index
Fund because of their extensive knowledge, expertise and experience.
However more often than not the opposite is true.
Now I do want to point out that when it comes to investing you can find numbers that prove
just about any point that you want to make.
It’s just the nature of the beast when you’ve got so many years of data to draw from, however
it does seem that more often than not passive investing wins out over active investing in
the long run.
And there have been tons of studies over the course of decades that have proven this to
be the case.
It turns out that only a small percentage of actively managed funds ever do better than
passive index funds.
In fact in an article from CNBC that I’ll link to in the description below, found that
between March of 2000 and September of 2016 only about 30% of actively managed large-cap
funds outperformed the S&P 500 over the course of any 3 year period during that time.
Of those that did, only a third managed to beat the market the following year, so a four
year period.
And only 13% managed to do it over a five year period.
And over a six year period, only 5% of actively managed funds outperformed the market.
That is insane!
And the percentages don’t change much if you look at mid or small-cap, or international
funds, or even emerging market funds.
That means that even if you’re in your early sixties and just starting to invest for retirement
you’ve got roughly a 1 in 20 chance of beating the market between now and the day you reach
retirement age if you only use actively managed funds.
But how can that be?
Most of the professional managers went to school for this and many have been doing the
job for years!
And it’s the job of an active manager to make you more money than you would have investing
passively yourself.
Shouldn’t they be able to do their job more than 5% of the time?
And the answer is, yes, so why can’t they?
Well this is primarily because none of us really knows what's going to happen in the
market a year from now or two years from now or heck even a couple of days from now and
even with all the analysis and expertise in the world the process of timing the market
is often times still little more than guesswork.
As I mentioned earlier active investing can also be very expensive with expense ratios
often hovering around the 1.4% mark compared to the 0.6% average for passive investing
funds.
Put simply, this means that for an actively managed portfolio to beat a passive portfolio
it has to outperform the market by more than 0.8% every single year.
And not only is that not easy to do it can also make a pretty significant difference
in your retirement fund.
And I will get into that in just a minute, but I want to finish explaining the concepts
first.
Some other advantages to passive investing are as I already mentioned the very low fees
associated with it because no one's having to analyze stocks and try and pick which ones
are going to go up and which ones are going to go down so the overhead cost is significantly
lower.
It's also very tax-efficient, because it's usually a buy-and-hold strategy which means
the capital gains taxes for every year are usually lower than it would be if you were
actively trading.
Now this can be offset in an actively managed portfolio by tax management strategies where
you sell off investments that are losing money, but it’s still worth noting because even
if you do that you’re still probably going to have to fork over more money in transaction
costs, at least if that’s the kind of setup that your manager has.
Many of them are starting to move away from that business model so here’s to hoping
that it’ll soon be a worry of the past.
Now to this point in the video, I’ve probably been sounding like a passive investing fanboy,
because of all the praise I’ve given it.
But that's not to say that it doesn't have its disadvantages as well.
Many people who favored active investing claim that passive investing is very limited, which
admittedly is true you're usually limited to a specific index or some other predetermined
set of investments, like the dogs of the Dow for instance and as a result there's not a
whole lot of variance.
With a buy and hold strategy like this you're kind of locked into whatever your Holdings
are no matter what happens in the market.
So a down year could be extra painful.
Some also feel that the returns can be very small in comparison because by definition
your matching the index so you're almost never going to beat the market.
And I feel like I’ve done nothing but bash active investing so far in this video and
it makes it seem like it has no merits of it’s own, which is of course untrue.
Some advantages to active investing are the flexibility that it offers you because since
active managers aren't required to follow specific index they can find those diamond
in the rough stocks if you will and get some really big returns in a short period of time.
Active managers can also hedge their bets using various techniques such as short sales
or put options and they're able to sell specific stocks or get out of certain sectors of the
market if the risks become too high.
Which can save the investor tons of money by avoiding losses... or cost them big time
by missing out on sudden gains.
Again it's like looking into a crystal ball more often than not you really just don't
know!
Now coming back to the idea of expense ratios let's see how much of a difference that 1.4%
average for actively managed portfolios makes compared to the 0.6% average of a passive
investment.
Take John for example, he's been investing $100 a month in nothing but actively managed
funds since he was 25 years old.
He is now 65 and getting ready to retire.
He has averaged a 6% rate of return over his investing lifetime, what would his net worth
be today?
Well he started with nothing, invested $100 a month for 40 years and got a 6% rate of
return.
Of course we have to take off the 1.4 expense ratio that he had to pay out every year so
effectively he got a 4.6% rate of return after expenses and when you punch the numbers into
a compound interest calculator you come out with a net worth of $134,839.84 at age 65.
Now let's assume that Jane did the same thing over the same period of time except she invested
in nothing but passive Investments.
I know this is a little bit hypothetical but the point is just to illustrate the difference
that expense ratios make over the long term so we're going to say that she also averaged
a 6% rate of return over the same 40 years and also invested $100 per month, just like
John.
The only difference is that she had an average expense ratio of .6% due to the fact that
the passive Investments are less costly.
So we punch the same numbers into the calculator, she starts at zero invests $100 per month
for 40 years with a 6% average rate of return take away the .6% expense ratio that she had
to pay out every year giving her an effectively a 5.4% rate of return after expenses and we
come out with a net worth of $164,598.22.
Now that may not seem like much but when you divide $164,598 by $134,839 you find that
Jane actually has 22% more in her retirement account than John does even though they got
the same rate of return and they invested the same amount of money over the same amount
of time Jane ends up with almost an extra $30,000 to her name.
And the difference only gets larger the more they put in, say for example both Jane and
John invested $500 a month over the same 40 years and both got the same 6% rate of return
jane would end up with just a hair under $823,000 by the time she reaches age 65 whereas John
would end up with $674,000.
Which means that now Jane almost $150,000 more than John when she's getting ready to
retire.
That's crazy right?
And let's say the market did better over the course of those 40 years say the market average
a 7% rate of return with everything else staying the same.
John and Jane invest $500 a month for 40 years at a 7% rate of return.
Jane ends up with $1,062,942.44 at age 65 and John ends up with $865,715.64, which is
a difference of just under $200,000.
So bottom line expense ratios do make quite a difference but as we've learned in this
video they're not the only thing that you need to focus on when choosing an investment
strategy.
Despite the heated debate between people who believe that passive Investments are the best
way to go and people who believe that active Investments are the best way to go it really
comes down to what you're looking for as an investor.
If you're young and you're looking to be in it for the long haul and you're willing to
ride the waves of the market passive investing is probably the better way to go for you.
The expenses are less, it's usually more tax efficient, and if you're able to ride the
market you're usually going to win out over the long term compared to an active investing
strategy.
However if you do have fun Trading, analyzing stocks, and you don't want to be locked into
certain Investments when the market goes down then perhaps an active investing strategy
would be your cup of tea.
But that'll about do it for me I hope you enjoyed the video and if you did or if you
learned something be sure to like And subscribe I've got a lot more of these Finance coming
out in the near future as well as some more book summaries and other fun stuff.
But with that being said, thanks for watching and have a great day.