Tuesday, May 17, 2016

Choosing Passive vs. Active Investing Styles ... Both Can Work Well but Only if Cost Effective and Managed for the Long Haul

The purpose of individual long term investing should be to accumulate assets which gain in value over time. The long term goal should be for these accumulated assets to grow appreciably by doubling several times in 'real' money, aka in inflation adjusted terms.

To do that, a portion of our earnings should be converted into long term savings which will result in growing value by appreciating on average annually at a rate substantially higher than the long term rate of inflation.

And to accomplish that feat, buying and holding blue chip dividend paying and growing stocks for the long haul is both a simple and successful approach. At least it's the one I've long and successfully followed for my personal investments.

Two things that long term oriented investors definitely need to do are (1) limit management advisory costs and (2) engage in a steady diet of common sense investing by respecting the always present elements of risk and reward.

These management advisory costs are simply what we willingly pay to knowledgeable others for help in managing our assets in a personalized and professional manner. Getting someone on our side who is interested and involved in our personal financial well being is always the start of ending up with a good 'game plan.'

We must also acknowledge that there will be a need to assume some investment risk in exchange for the opportunity to achieve long term inflation beating financial security and rewards. It's just that simple.

How we choose to go about all this is up to us, of course, but go about it we definitely should.

So with that in mind, let's examine which investing approach and style is better for us, passive or active? The answer, as are most all good and thoughtful answers to most questions, involves an informed choice that each of us must make for ourselves.

John Bogle gets the last laugh tells one side of the story regarding the choice between passive index fund investing compared to active investing:

"The Vanguard 500 Index Fund, which tracks the S&P 500 Index, celebrates its 40th birthday this year. In 1976 it became the first index fund available to individual investors and started an investing revolution. The Vanguard Group, under the stewardship of John Bogle, was just 16 months old at the time. Bogle believed that it would be difficult for actively managed mutual funds to outperform an index fund once management fees, operating expenses, sales commissions, taxes and portfolio transaction costs were subtracted from returns. His goal was to offer investors a diversified fund at minimal cost that would give them what he called their "fair share" of the stock market's return.

In its initial public offering, the fund brought in only $11.3 million; which wasn't enough to purchase all the stocks in the S&P 500 Index. Soon, Vanguard's competitors began calling the fund "Bogle's Folly." They insisted that investors wanted nothing to do with a fund that, by its very nature, could never outperform the market....

Fast forward 40 years and about 20% of all money invested in domestic stocks is invested in Bogle's Folly and its descendants. Investors can purchase shares of tax efficient, low-cost index funds in almost every global asset class. . . .

No longer can actively managed funds just offer a diversified portfolio of securities — they need to outperform index funds to compensate investors for their higher costs. Most fund managers believe that they're up to the challenge, but an honest observer must conclude that most have failed to do so. . . .

For the 10 years ending Dec. 31, 2015, 82% of large-cap, 88% of mid-cap and 88% of small-cap actively managed domestic stock funds underperformed their S&P benchmark index.... Bogle's Folly, indeed.

So why do most investors still buy actively managed funds when most of these funds underperform their index competitors? The main reason is that most investors don't understand the difference between active and passive investing. . . .

Investors discuss investments with friends, neighbors and coworkers, and these interactions tend to promote active investing. Everyone has experienced a "water cooler windbag," someone who broadcasts a litany of his investment successes. This bragging rarely includes any mention of investment losses, likely overstates the gains and provides listeners no way to verify the claims.

Fund managers know that if they can produce market-beating performance long enough to attract media attention, they'll attract thousands of new investors. Thus, they're likely to own riskier stocks, hold concentrated, undiversified portfolios, trade frequently or engage in speculative trading strategies. Most outperforming funds are more volatile than the market; making it likely that they'll eventually underperform by a significant amount — to the dismay of shareholders who arrived late for the party.

Wall Street's representatives never mention what John Bogle has often said — that average market returns have been sufficient for most investors to meet their financial goals. Its business model is greed focused — acting as if there is no such thing as "enough." Its advice is market-focused because market volatility provides frequent opportunities to advise clients to do something that will generate new fees and commissions.

Investors need goal-focused financial planning. Planning that centers on preparation and protection, not predictions or performance. Planning that helps clients organize their lives and assets to achieve their goals with the least amount of risk exposure. Combined with passive index investing, it's not an exciting message. But for most investors it has proven to be more rewarding than embracing Wall Street's ongoing attempts to outperform the market. Bogle's Folly or a fool's errand. It's your choice."

Summing Up

In the beginning years of investing, I used both passive and active approaches. Either way can work well.

Through years of experience and learning, I've chosen to manage my investments actively in preference to passively taking what the broader market gains or loses.

My long followed game plan is to stay invested in each individual stock for the long haul and not to let the short term and often highly volatile price swings 'scare' me out of the market when the fit hits the shan. Winning the savings and investing 'game' is indeed a long one which requires that we keep playing.

If we watch the costs carefully and work with a knowledgeable low cost investment adviser, active management is definitely a winner for the long haul.

But whichever personal investment route you decide to take, do yourself a favor, start young, save regularly and invest those savings in blue chip dividend paying stocks for the long haul.

And never confuse short term market volatility with long term market risks and rewards.

That's my take.

Thanks. Bob.

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