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Active vs. Passive vs. Behavior

August 18, 2018
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Whether you're just getting started investing, or have experienced the ups-and-downs of the market for decades, you have probably read about "passive investing" and "active investing" and the pros and cons of both. Regardless of where you read it, or perhaps heard about it on TV from some "investment gurus", there always seems to be arguments for both styles of investing. With the recent rise of expense-adverse investors comes increased attention to this passive vs. active debate, but is this really the problem?

The majority of those arguing and researching over which style is superior often commit to one camp or the other (there seems to be no in between). Our question is simple: Why Not? We see potential benefits to both strategies and we use both with our clients depending on their needs. The truth is, both investment styles have potential to help our clients pursue their financial goals. We feel it is more important to stick with your investment plan rather than which investment style is used.  We believe the real determining factor in this debate is not active or passive investing, it's investor behavior

   

Why Investor Behavior? Time for a hypothetical example to help illustrate my point:

Two brothers; "Miller" and "Bud", each own a portfolio of investments. They have both been investing now for 25 years, and started their investments at the same time with $10,000 each. Neither of them have taken any withdrawals from their accounts. Miller has owned most of the investments in his portfolio for the entire 25-year period and has made very subtle changes. Buds's current portfolio looks much different than it did just last month, 6-months before then, and completely different than it did last year. As of today, Miller's account balance is $70,000, and Bud's account balance is $50,000. Did Miller just happen to pick better investments than Bud?  Not necessarily.

Miller implemented a goals-based investing approach based on specific investment plan. Miller invested according to the plan and for the most part stuck to it ever since. Miller hasn't engaged in market timing or trying to pick the next hot investment. 

Bud on the other hand, developed a portfolio based on "trending" investments that had provided great returns over the previous few years. However, a few years after he started, his portfolio began to have negative performance. He promptly decided to sell a majority of his holdings and re-invested in completely different types of investments that were exhibiting positive performance at that time. Shortly after his total portfolio makeover, his portfolio started to trend downward. Once again, not knowing how far it could drop, he decided to alter the portfolio. This time Bud thought he would "sit on the side lines" and wait out a bad market. A few months later the market was trending up and Bud reluctantly invested back in at a higher price, fearing he would continue to lose out on the potential bull run. Bud has been investing based largely on emotions for 25 years and has never had a specific plan in place to guide him based on his financial needs and goals. He has been chasing returns and consistently attempts to time the market. This behavior has also caused him to miss crucial days in the market. Without a plan he was left to his own devices and emotions drove his investment decisions.

Again, this is a completely hypothetical example but a more common approach to investing than you may realize.  In our example, this irrational investment behavior has led Bud to have inferior portfolio performance when compared to his brother. This is known as "investor behavior", and we believe it plays the biggest role in an investor's overall performance.

Here's my white board version...

This is for illustrative purposes only and does not represent actual performance of any specific investment or portfolio.
All investing involves risk, including the potential for loss of principal.

Bottom Line:

There are many styles of investing and the debates about them will rage on, but if investors cannot separate emotions from investing they may find themselves in a revolving-door of poor performance. In fact, according to a Dalbar study, investors consistently under-performed the S&P 500 over the long run.1 We find that the basic argument between active and passive misses the boat entirely. Yes, each investment style has its uses and should be analyzed and compared among its peers. However, rather than making that your core focus, try starting with a goal for your investment dollars and creating an investment plan you truly believe you can follow. Whether it's passive investing, active, or any other style, it's important to make sure it's something you can be comfortable with for the long-term. Better yet, get with a financial advisor and create a comprehensive, values-based financial plan for you and your family. Financial planning can help you assess the probability of obtaining your goals, and help show you how to adjust accordingly.

Cameron Valadez is a CFP® Practitioner located in Riverside, CA and prefers Coors.

   

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

This is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.  The S&P 500 index is unmanaged and cannot be directly invested into. Past performance is no guarantee of future results.

1 https://www.dalbar.com/QAIB