61% of Americans invest in order to achieve their goals. Be it retirement, travel, starting a business, supporting others, or simply earning higher returns – the ultimate goal of investing is to make more money or preserve the value of your money. Nevertheless, achieving that goal is where it gets a little tricky.
Active and passive investing are two investing strategies. They have different goals and lead to different outcomes, and it’s important to understand which one fits your unique needs and makes your money work in the markets.
What Does Active Actually Mean?
Differences Between Active and Passive Investing
Most investors consider “active” investing to be stock picking with the goal to outperform the broader market (i.e. S&P 500 Index). The investor (or the financial advisor on behalf of the investor)buys or sells individual stocksbased on specific factors, hoping to pick more winners than losers.
“Passive” investing has a buy-and-hold approach with the goals of generating long-term market returns. With passive investing, youbuy investments in a benchmark indexwith the goal of accepting benchmark returns while reducing trading expenses and improving tax efficiencies. Thetrendover the last decade is investors buying passive mutual funds and ETFs while selling active strategies.
Historically, there is a lot of debate on the “active” vs. “passive” investing topic and whether there’s an actual value-add to pursuing active investing.
Consistent with the advisors in our network, we believe thatit’s time to shift the conversation from an “active” style of investing to a long-term, disciplined wealth creation strategy.
Before we dig deeper and evaluate whether or not your portfolio is active (and what that actually means), it’s crucial to first point out that the way people invest has changed over time. Let’s take a tour through the evolution of investing to better understand how we ended up in today’s investing landscape.
Times Have Changed
Prior to World War II, individual investors mostly owned individual stocks.
In the 1950s, mutual funds started to gain traction as they brought down the cost of ownership and thus democratized investing to a broader set of investors. Mutual funds had their biggest inflection point though after the introduction of the 401k through the Employee Retirement Income Security Act (ERISA) in 1974. The bull market of the 1980s and 1990s further contributed to the adoption of mutual funds (both index and active funds).
Exchange-Traded Funds (ETFs)were introduced in the 1990s and provided an improved way of investing. They tracked indexes at a lower cost and a more tax-efficient way while trading on stock exchanges as regular stocks do!
Not only did ETFs provide broader access to domestic stocks, but they also provided access to international stocks, commodities, and currencies that were previously not easily accessible to individuals. According to areportfrom the Investment Company Institute, after the ‘08 Global Financial Crisis, ETFs gained further adoption and grew from $531B to approximately $5.45T from 2008 to 2020.
With the backdrop of commission-free stock trading, a new way of owning stocks has emerged:Direct Indexing. Direct Indexing allows for truly personalized and customized portfolios without having to “pool” different people’s money. In other words, it is the equivalent of building your own unique ETF.
The evolution of investment vehicles has also transformed the role of the financial advisor.
Understanding Wealth Creation Today
Instead of an activeinvestmentmanagement style, we believe in anactiveframeworkthat provides a rigorous, objective, and holistic approach to investing.
There are several investment frameworks that can help you achieve your financial goals. The key is to have a framework and the discipline to stick to it.
So how are advisors working with an “active” framework? Most of the action will happen behind the scenes.Here is an example of the activities an advisor would do:
- Create a list of investable Asset Classes.
- Develop a Strategic Asset Allocation using historical and forward-looking expectations of the asset classes.
- Select appropriate Asset Allocation consistent with your preferences (risk, goals, time horizon).
- Choose the investment styles (passive/hybrid/active) along with the investment vehicles (some of the widely used ones are below):
- ETFs
- Mutual Funds
- Individual Stocks
- Follow a disciplined and tolerance-based approach to rebalance accounts & minimize drift between you and your target portfolio.
- Regularly monitor portfolios to ensure you stay on track to achieve your goals.
- Check-in with your advisor on a regular basis to ensure your situation has not changed enough to merit an adjustment to the set goals and investment strategy.
6 Ways the “Active Framework” can Provide Value
Hint… it’s not about beating the market:
- A goal-based approachleads to a higher client engagement and a greater likelihood of sticking to the plan with fluctuating markets.
- Selecting theright asset allocationcould have a huge impact on overall progress for your goals… According toresearch,90%+ of portfolio returns could be attributed to asset allocation.
- The disciplined process ofchoosing/developing the investment strategyhelps maximize the risk-reward potential while minimizing the overall costs.
- Regularportfolio rebalancinghelps with minimizing portfolio drift (the difference between the current and target portfolio) while keeping emotions out of the day-to-day portfolio management.
- Advisors shouldbekeeping you motivated and accountablefor staying on track especially during market swings.
- In short, life is fluid and ever-changing… And your financial plan should be too!
The Bottom Line
Active investing is not a get-rich-quick scheme. Although most people may think of it as a stock-picking strategy that outperforms the market, we believe in using it as a framework, rather than an investment management style.
Selecting the right asset allocation can provide a huge impact on the progress of your financial goals, and this is one of the many ways an active framework can provide value to your investment strategy.
Building wealth while navigating through the challenges in life is a marathon and not a sprint. If you manage to build a consistent process that you can follow and keep up with, you will be able to drive more outcomes.
As an experienced financial advisor with a deep understanding of investment strategies and wealth management principles, I can provide insight into the concepts and strategies mentioned in the article you provided. Here's a breakdown of the key concepts:
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Active and Passive Investing:
- Active investing involves trying to outperform the broader market by selecting individual stocks based on specific factors. It typically involves more frequent buying and selling of assets.
- Passive investing, on the other hand, aims to match the performance of a benchmark index by buying investments in that index. It usually involves a buy-and-hold strategy with fewer transactions, focusing on long-term market returns while minimizing trading expenses and taxes.
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Evolution of Investing Vehicles:
- Before World War II, individual investors primarily owned individual stocks.
- Mutual funds gained popularity in the 1950s, offering diversified portfolios at lower costs.
- The introduction of the 401k in 1974 further boosted the adoption of mutual funds.
- Exchange-Traded Funds (ETFs) emerged in the 1990s, providing a more cost-effective and tax-efficient way to invest in indexes and various asset classes.
- Direct Indexing, a newer approach, allows investors to build customized portfolios without pooling funds.
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Active Framework for Wealth Creation:
- An active framework emphasizes a rigorous, objective, and holistic approach to investing.
- It involves creating a list of investable asset classes, developing strategic asset allocations, selecting appropriate investment styles and vehicles (such as ETFs, mutual funds, or individual stocks), and regularly monitoring and rebalancing portfolios.
- Advisors work behind the scenes to ensure that clients' portfolios align with their goals, risk tolerance, and time horizon.
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Benefits of an Active Framework:
- A goal-based approach enhances client engagement and adherence to the investment plan, especially during market fluctuations.
- Selecting the right asset allocation is crucial, as research suggests that over 90% of portfolio returns can be attributed to asset allocation.
- The disciplined process of choosing and managing investments helps maximize risk-reward potential while minimizing costs and portfolio drift.
- Advisors play a vital role in keeping clients motivated, accountable, and on track with their financial goals, particularly during market volatility.
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The Bottom Line:
- Active investing is viewed not as a short-term strategy for beating the market but as a long-term framework for wealth creation.
- Selecting the appropriate asset allocation is paramount for achieving financial goals, and an active framework can add value to investment strategies by providing personalized guidance and discipline.
By understanding these concepts and implementing sound investment strategies, individuals can navigate the complexities of the financial markets and work towards achieving their long-term financial objectives.
