When folks find out we’re financial advisors, they often ask how they can get the best returns on their investments. They tend to expect us to list a single investment strategy as a way to beat the market. In reality, though, the best approach is usually working with an advisor who can combine different approaches to investing to create a portfolio designed with your goals and timeline in mind.
Recently, we’ve gotten a lot of follow-up questions on passive investing and index funds. But those can be fairly complex questions to answer. In this article, we’re digging into what passive and active investing are and how both of those strategies translate to index funds, exchange-traded funds (ETFs), and mutual funds. Along the way, you’ll see why we developed our current approach to investing.
Passive investing, explained
At its most basic level, passive investing means you don’t do anything. It’s a buy-and-hold approach favored by big name investors like Warren Buffett. With individual stocks, this usually means investing in companies you believe in, long term, based on their underlying fundamentals.
It also means ignoring day-to-day market moves, which can lead to emotional or impulsive decision making. When you follow a passive investment strategy, making short-sighted changes based on sudden market movements can cause long-term losses.
Active investing, explained
Active investing is, as its name suggests, a more active approach. It involves picking stocks based on market trends, trying to time when to buy and sell, and in general working to maximize potential profit with a hands-on strategy.
These core approaches to investing can manifest themselves beyond buying and selling individual stocks.
How to take a passive/active approach to investing
In the last two decades, passive investing has grown in popularity while active investing has fallen out of favor with DIY investors. And there are a few good reasons for that.
Active investing requires research, may involve trading fees that can eat into potential returns, and often requires the investor to understand logistical aspects of trading, such as limit versus market orders. To be profitable, an active approach must generate return in excess of any fees, commissions, or tax liabilities involved in trading.
Active investors who don’t want to stock pick can put money into actively managed mutual funds or ETFs. There’s still active research involved, though. It’s important to research the fund manager’s track record alongside any management fees or operating expenses that may eat into returns.
Passive investing generally translates to buying and holding index funds. If you don’t want to actively pick stocks, these index funds offer exposure to the market. Index funds can be either mutual funds or ETFs; they’re designed to track key benchmarks, so performance mirrors the index the fund tracks, less fees. Passive funds tend to have lower management fees, since the manager isn’t picking stocks. (Sometimes, these funds are managed primarily by algorithms.)
While you may be inclined to pursue one strategy over the other, it’s still important to consider the pros and cons of each. Most 401(k)s, for example, include both active and passive funds in their offerings. Understanding how these funds work can help you select the right ones to meet your needs.
If you don’t want to dig into the details, Revo Financial works with clients to help select appropriate funds within employer-sponsored plans.
The advantage of investing with an advisor
Perhaps one of the biggest advantages of working with a financial advisor is that we build you a tailored investment strategy based on your assets, goals, and timeframe. By taking a big picture perspective, we can balance both active and passive approaches across your portfolio.
One of the biggest drawbacks of active investing as an individual investor is the tendency to make emotionally driven and under-researched decisions. Unless you have the time, data, and experience to analyze markets and stock performance, it’s easy to let emotion drive investment decisions. This is especially true during periods of market volatility or economic uncertainty.
The reality is, by the time investors see headlines on the nightly news, the information is already outdated (at least from a trading perspective). Even real-time market updates on financial news channels and websites can be outdated.
Most trading is done electronically these days, versus on the floor of a stock exchange or broker/dealer. That creates an environment where algorithms and machines can spot trends—like a sell-off—before humans do. Machines can also cross-reference trading data with data from social media, news sites, and more.
In this environment, we find an active, data-driven approach to investing makes the most sense for our clients. We can create a data-driven investment portfolio designed with your needs in mind.
That’s why Revo Financial uses a quantitative, data-driven research partner – Helios. Helios uses algorithms and data to make recommendations for adjustments that aim to maximize returns and reduce risk in alignment with stated goals. It’s an active approach that strips emotion from the equation, using research, data, math, and your personal circumstances instead.
