Picture this. Two cars are driving down a three-lane highway. A red sports car is darting between all three lanes, trying to find the fastest possible way to get ahead. A gray sedan is in the right lane, steadily going the speed limit. Suddenly, a train horn sounds and in the distance, the arm for a train crossing shuts down. Despite the red car driver's best attempts, he misses the narrow window and comes to a screeching, hair-tingling halt at the crossing, right next to the gray sedan.
If this were investing, the red sports car would be called active investing. The gray sedan would be a style called passive (or "evidenced-based") investing. Why should you care? Because the data shows that, boring as it may be, a passive style of investing has historically outperformed the sexier, active style. As a female financial advisor, I am often asked about the pros and cons of each style. Here are some thoughts to help you decide which is right for you.
What do active investors do?
Active investors believe that markets are "inefficient." They believe that, at any point in time, there are always some securities that are mis-priced, enabling them to buy (or sell) them at a profit. Professional active investors devote an unbelievable amount of time and resources towards trying to find that extra edge. They will then trade in and out of those securities to try and generate profits. They pour over company financials, visit with competitors, study all the latest economic releases and try to predict everything from corporate earnings to the direction of interest rates. You can think of this as the extra wear and tear (and stress!) that comes from being the driver of the red sports car, weaving in and out of traffic and having lots of sudden stops and starts.
What do passive investors do?
Passive investors believe that markets are "efficient." They believe that, over the long run, the price of stocks and bonds reflect the true underlying value of those securities. As such, they do not seek to beat the market, but rather to "be" the market. They do this by using index funds and ETF (exchange traded funds) that mimic various components of the market. For example, rather than try to find that "next Apple or Google," you can purchase (nearly) all large U.S. stocks or (nearly) all small emerging market stocks in one fell swoop. Then, using a process called asset allocation (picking the right mix of each of those slices), they can create a portfolio that has an appropriate risk exposure for the client. You can think of it as the gray car driving at different speeds depending upon what the speed limit is on any particular road.
Which style of investing performs better?
Survey says.... Passive investors outperform active investors more often than not. In the past five years, 75% of U.S. Large Cap funds, 90% of U.S. Mid Cap funds and 83% of Small Cap funds failed to beat their comparable indices. One reason for this may be the fact market surges (up or down) are stubbornly unpredictable. And as this slide based on data from Dimensional Fund Advisors shows, even missing just the top 25 days of market performance over the last 40 years would result in you having 3.6% less per year than if you had just stayed the course.
Which style should you use?
Looking at investors as a whole, active remains by far the more popular style. As of December 2011, 79% of mutual fund dollars were allocated to active, and 21% to passive. Which style of investing you want to use depends upon both whether or not you think markets are efficient and your risk tolerance. Do you want to invest like the driver of the red car and have the possibility that you might beat the train to the crossing (or might have a horrific accident along the way)? Or do you want to invest like driver of the gray sedan, having a less exciting ride but higher odds that you get where you want to go on time (but likely not early)? Only you can answer the question. For more on active versus passive investing, I recommend reading The Investment Answer by Dan Goldie and Gordon Murray.
This post originally appeared at MoneyZen.com. For more MoneyZen in your life, follow Manisha on Twitter at @ManishaThakor, on Facebook at /ManishaThakor, or sign up to receive Manisha's MoneyZen blog via email by clicking here