Why you need to know the difference between passive and active investing

All investing takes form in either a passive or active manner.  Knowing the distinction will help you determine what is more appropriate in reaching your goals.

They are two sides of a coin and have some stark differences.

Passive investing means you purchase an instrument that is a replica of the market you wish to invest in.  For example, a passive investment into the Thai stock market means that you purchase the entire SET Index.

Active investing is anything that differs from the index.  If you purchase shares in a publicly listed company, you are partaking in an active strategy and hope to do better than the overall market (index).

Passive investing is a simple means to an end

Investing strategies that are passive want exposure to an already existing basket of investments.

This can come in many shapes and forms.  In equities, investors looking for passive exposure to the Thai market can purchase a basket replicating the SET Index.  Similarly, there is an index for global equities that investors can purchase.

One element that distinguishes passive investing from active is that the human element is carved out.  Passive investment funds do not require fund managers that select specific instruments that end up in your investment basket.

This results in lower fees which is driving more investors to invest passively. According to Bloomberg, passive investment funds are set to surpass active investment funds worldwide in terms of assets under management by 2026.

Passive investing is an excellent way to achieve broad market exposure and diversification.  For investors looking for a ‘buy and forget’ type of approach, this is a great option as you only need to concern yourself about market returns and not whether the instruments in the basket are superior than other available options.

Active investing is more deliberate

As the term suggests, active investing is more hands-on. 

Investment decisions with this approach are made with a particular goal in mind.

Everything in investing is relative, and there is always the passive alternative to invest in the index.  Therefore, prudent active investing is best served by seeking an objective not otherwise available by investing in said index.  This can take form in wanting to achieve higher-than-market returns, or lower volatility than the index, for example.

Whilst there is no right or wrong, we believe that investors need to have a sound reason for pursuing active strategies over passive.  Why complicate matters unnecessarily if you do not have reason for it?  The next time someone tells you about a great stock tip they have, ask them why they are not just investing in the market index instead?

This is important because active investing by nature opens you up to a higher range of outcomes.  You may achieve great returns if things go well, and the flipside is also true whereby your losses may be higher.

Factor in costs and your time when deciding

One of the primary distinctions between active and passive investing lies in decision making and costs.  Active investing requires substantial time and effort to research and analyze investments.

At the same time a highly active investor may incur more capital gains tax and brokerage fees while a passive investor does not.

While a passive investor may prefer not to make decisions, not monitoring the portfolio at all leads to imbalances over time.  In such an instance, certain investments may become a large part of the pie, leading to higher volatility.

Uncommon sense to invest better

• Many of the principles behind successful investing are intuitive and easy to understand.  What complicates matters is our tendency to forget them in times of uncertainty when emotions take over and fog windshields.

• In this post we have outlined a few reminders to keep us on track.  This includes the benefits of keeping things simple and by operating counter-cyclically.

• Instead of focusing on how much money can be made, we think it may be prudent to first look at how much can be lost.  Protect your downside before planning trips to the moon.

• Mistakes are inevitable in investing and trying to be perfect is futile.  Being less error-prone can have huge payoffs, and made possible by being disciplined and identifying where we are most vulnerable.

Less is more

We live in an age of abundance, which is not always a benefit when it comes to investing.  There is no longer a lag when it comes to the transmission of information.  Boundless investment options are available to investors today, with new asset classes and products emerging by the dozen.  Care about the environment and want to invest your money?  There are thousands of options available.  Unfortunately, this is not always helpful.

Investors can monitor changing values of investment portfolios in real-time. Decades ago, you would need to wait for physical statements to be sent in the mail for an update on their portfolios.  Today, you can trace every tick up and down for a stock. For some types of investors, there is an actual need to manage portfolios daily.  Institutions need to manage redemptions and have other liquidity requirements.  I suspect that most investors that identify as long-term do not fall into this category.  Consider that there are around 250 trading days in a year.  For those that hold a 5-year investment horizon, 1 trading day is less a tenth of a percentage over this time.  90 days – one quarter – accounts for 7% of time over that 5-year period. Daily share price movements tell us little about how fundamentals are evolving and more about how sentiment is on a given day.  Placing undue attention on day-to-day changes can easily distort focus. 

Asset prices are made up of two components: fundamentals, and how people feel about those fundamentals.  The latter is sentiment.  In most cases, long-term value is a function of the fundamentals.  Businesses generate earnings, and the quality and quantum of these earnings impact how much they are worth.  Kodak Eastman produces far less money today than they did decades ago, and this is reflected in how much the business is worth.

There is no scarcity of investment options that investors now have access to.  In Thailand, banks use a model that is akin to supermarkets to peddle investment products to investors.  There is a fund or a product for every geography, asset class, investment style from a swathe of investment companies.  Enough to fill many neatly organized aisles.  How are investors meant to make informed choices as to what and how much of these products to purchase?

Diversification is great.  But only up to a certain point.  Investors loading their shopping carts with funds and products from all corners open themselves to the risk of diworsification.  Holding so many different investment products can make taking a holistic view of a portfolio difficult.  It can also impair decision making in times when markets are volatile, and when portfolios need to be rebalanced.

One of the things that makes investing difficult is that there are many unpredictable factors involved.  Without being careful, it is easy to get swayed by noise and drown in confusion.

Look down, not up

When evaluating investment options, it is commonplace to think about how much money you can make.  What the potential return is.  We advocate that working backwards is better.  To first consider how much potential risk and/or downside is on the table.  The benefits include avoiding unwanted surprises and aches to the head and pocket.

Different investments – even in the same asset class – have varying risk profiles and characteristics.  Risk means different things to different people, and for us mostly relates to the likelihood of your principal being lost.  In equities, the risk in owning a single stock and a basket of stocks is vastly different.  The likelihood of one company – even a great one – going extinct is far higher than a basket of companies. 

One way I have seen this play out is with investors opting against deploying capital in corporate bonds in favor of dividend paying stocks.  The rationale behind this is that the dividend yield on offer is 2x higher than the coupon being paid on the bond.  This is a gross violation of comparing apples and oranges as the profiles of the two investments are vastly different.  Owning shares in a common stock exposes you to price volatility that otherwise would not be relevant if you were holding the bond to maturity.  The dividend you receive may fluctuate depending on the cashflows of the business.  If you are a bondholder, if the company does not go broke you are likely sleeping well.  Easy to ignore if we have tunnel vision and think only about the return on offer.

By paying attention to the downside, investors can better make capital allocation decisions.  Investing is asymmetric in nature.  The most you can lose is your investment, whereas the upside is as high as returns and time dictates.  Like a tree that can be burned by fire or grow to be as tall as the canopy.  To make this work in your favor, it is key to know the different variables that can impact and endanger your investment.  If you plant enough trees and minimize the impact of fires, sunlight and time can take care of the rest.

Go against the grain

Doing something different from the masses can be rewarding for investors.  It is easy to be swayed by sentiment and shy away from deploying capital when conditions appear bleak.  Similarly, it feels most comfortable investing when optimism is in the air.

This is most prominent in auction-based financial markets where collective decision-making drive prices higher and lower.  The participants in these markets are human beings, prone to making emotional choices and following the herd.  The result is that markets tend to overshoot on both sides, producing extreme optimism and fear.

This is why Warren Buffett says to be “fearful when others are greedy, and greedy when others are fearful”.  Forward returns are the highest after a collapse in prices.  This is intuitive and easy to forget when markets and portfolios are on fire. 

In investing, tomorrow matters more than today as markets price in the future.  Doing something different requires courage and can be difficult.  It can also make you look stupid in the near-term.  If approached with discipline, this can lead to outsized benefits down the line.

Common sense is common, just easily forgotten

None of these observations are prescient.  You already know most, if not all of this.  They are simple truths that apply to investing and other disciplines.  The problem is that a lot of this gets thrown out of the window when the queasy feeling of uncertainty arises.

Detaching emotions from decision making in matters of money is not common for human beings.  We can thank our ancestors from the savannah for that.  Realizing our tendencies to give in to temptation when things do not go our way can help develop awareness for better decisions.  If this can lead to fewer mistakes, the better our chances are of planting trees that grow tall.