How to Take Charge of Your Investments: Active vs Passive Investing

by | Investing & Personal Finance

In his most recent Berkshire Hathaway annual report, famed investor Warren Buffett praised Jack Bogle, founder of The Vanguard Group and inventor of index investing. “If a statue is ever erected to honor the person who has done the most for American investors,” Buffett said, “the hands-down choice should be Jack Bogle.”

With index investing, investors buy a basket of stocks or bonds. (Investors cannot directly invest in an index.) The most popular index is probably Standard & Poor’s 500 (S&P 500), which tracks the 500 largest companies on the NYSE or NASDAQ and is a staple in the menu of investment choices that many of you have in your 401(k)-plan.

Moreover, most stock-market indexes, including the S&P 500, are market-cap weighted: the bigger the company, the more representation it gains on the index, hence in your investment option. Today, if you were to allocate a percentage of your 401(k) to it the largest holding represents approximately 3.7% and the second largest holding represents 2.6%.

And it is not just blue-chip stocks. Virtually any asset class can be invested in with an index that includes small-cap stocks, bonds, high-yield bonds, foreign stocks, commodities, etc.

The opposite of index investing is active management, in which a portfolio manager or managers construct a portfolio one security at a time. By dissecting the prospects of a company’s stock or bonds, the manager hopes to create a portfolio that can outperform the market and the indexes.

Over the last ten years, however, $1 trillion of investors’ money has moved from active to indexes. A big reason for this is that, over that same period, most active managers have underperformed lower cost-index options.

Worse yet, during the Great Recession, during which one hoped active management could reduce a portfolio’s losses (even though the S&P 500 index lost approximately 50%), active managers did not perform a whole lot better, suffering losses similar or, in some cases, worse.

The significant long-term advantage of index investing is lower costs, as the fees charged to investors are significantly less than those in active management. This is because index investing has no managers to pay, as no one is researching and picking the securities.

However, what Buffett and Bogle fail to recognize—or, at the very least, acknowledge—is that all of those active managers trying to beat the market are what makes the market efficient: because of them, most individual securities get priced correctly. Thus, with no bargains for active managers to swoop up, investors might as well buy a lower-cost index.

So, while Buffett praises Bogle and indexing, he minimizes the importance of active management to the outperformance of indexing. Plus, if more and more investors switch to index investing, then less and less research and active management will get done. This could create more bargains and set the stage for the investing world to flip back to benefiting from the security selection once highlighted by Buffett’s mentors, Benjamin Graham and David Dodd, in their famous 1934 book Securities Analysis.

These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Securities offered through Cambridge Investment Research, Inc., a broker/dealer, member FINRA/SIPC. Investment advisory services offered through Cambridge Investment Research Advisors, Inc., a Federally registered investment advisor, 39 Braddock Park #5, Boston, MA 02116 | |126 Horseneck Road, S. Dartmouth, MA 02748.

Sources:

Braham, Lewis. “A Seismic Shift is Happening, and Billions are Pouring Into These Index Funds and ETFs.” CNBC, April 17, 2017. http://www.cnbc.com/2017/04/17/a-seismic-shift-is-happening-and-billions-are-pouring-into-these-funds.html

Graham, Benjamin, and David L. Dodd. Security Analysis. Sixth Edition. Foreword by Warren E. Buffett. New York: McGraw Hill Education, 2008.

Levy, Rachael. “Warren Buffett Just Said This Man has Done the ‘Most for American Investors’.” Business Insider, February 25, 2017. http://www.businessinsider.com/warren-Buffett-praises-vanguards-jack-bogle-in-annual-letter-2017-2

“S&P 500 Companies by Weight.” SlickCharts. 2017. http://slickcharts.com/sp500

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Tim has been a professional financial advisor for 26 years. He specializes in building custom portfolios for people that are saving their money for retirement or are already retired.

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