Some people advise investing in indexes. Others urge you to choose your stocks carefully. Who is right? It seems that the two most popular investment tips contradict each other.
First tip: “Don’t try to outplay the market.” It is based on numerous studies that show that no one manages to get higher returns than they can get by simply investing in indices if considering a sufficiently long period.
Second tip: “Study everything carefully before buying stocks.” But it follows from the first point that this is not necessary. The stock market is efficient, so the current stock price of all companies is, in a sense, fair. You cannot unknowingly buy a share that is too expensive, because if it were really too expensive, someone would be able to take advantage of this and outplay the market, and this, as we know, does not happen.
In fact, the first tip means that you can just buy random securities. Buying random securities will, on average, give the same result as the entire market. The differences here will be only in the range: the ETF will have a worse result.
What to Do?
These two tips do seem to be contradictory but one cannot say that one of them is unambiguously correct, and the other is wrong. They are simply different approaches to investment: passive and active, respectively.
In the American textbook Essentials of Investments, these approaches are defined as follows:
- Passive investors hold a broadly diversified portfolio of securities and do not try to increase their return on investment by analyzing securities.
- Active investors look for undervalued securities, try to predict market trends, and choose the optimal time for transactions in order to increase the return on investment.
Let’s have a look at the main difference between active and passive investments, so you can choose what works best for you.
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Active Investments
The key is to invest in the best companies or industries or to choose the most appropriate time to make deals. This gives you a chance to get profitability above the market average. The market is not always efficient, so it is possible to find securities that are too cheap or sell those securities that are unreasonably expensive at the peak of the price. To do this, investors study company reports, calculate multipliers, follow the news, and asset prices. If you can find the best securities, the return on investment could be much higher than the market average.
A good result is not guaranteed: you can make a mistake, overlook something, or suffer from unforeseen events. Common investors, experienced analysts, and even Warren Buffett are mistaken. In recent years, the profitability of his holding, Berkshire Hathaway, has repeatedly lagged behind the S&P 500, and he himself admitted his investment in Kraft Heinz was unsuccessful.
Passive Investment
Passive investors do not opt for individual securities. They are invested in all securities at once, taking into account their market share. If the capitalization of shares of company X is 3% of the capitalization of the share market, the share of X in the portfolio of the passive investor will be 3%.
The yield will be close to that of the index, that is, to the market average. It will not be possible to get a return higher than the index, which is why many are interested in active investment, not passive.
But over long intervals passive (index) investments perform better than active ones. Most actively managed stock and bond funds have lower returns than their respective indices. This can be seen, for example, according to the SPIVA data.
The more time passes, the higher the chance that index investments will perform better. In addition, the passive approach is much simpler than active management.
What to Choose
Active investments are great if you are willing to spend tens or hundreds of hours a year searching for investment ideas and portfolio management. Passive investments are suitable if you have little free time or do not want to understand terms like EBITDA and P/BV.
A compromise option is to combine approaches. Part of the money can be allocated for passive investments and part for active strategies. Over time, you will understand what suits you best and if you are good at picking individual securities and time for trades.
