After the broad diversification and asset allocation decisions, you can define specific investment alternatives. However, before choosing your vehicles and investing, you must make a fundamental choice between active and passive management.
Stock picking implies choosing a limited number of stocks and market timing means that you buy or sell at specific times in the hope of making a profit: This selection of investment and timing is called active management: Finance gurus and many stock picking newsletters promise advices to beat the market. A thriving industry follows this principle, from Wall Street to Paradeplatz. However, the costly advisers and mutual funds advocating active management have shown limited success when they compare to the market return over the long-term. Beside very limited successful exceptions, mostly based on cutting-edge IT infrastructure and secretive trading strategies of hedge funds and proprietary trading companies, it is almost impossible, to succeed at market timing over the long run. Consequently, the significant fees gathered by the active managers and financial intermediaries are the portion of the returns that is removed from investors’ pockets.
Numerous studies have revealed that on average, the investor will lose his bets with the market, as investors are unable to consistently perform above the market. In contrast, with passive investing, you invest in a collection of stocks representing the market. These collections of stocks for a particular market are indices. As pointed out by Rick Ferri in “All About Index Funds”, “in the 1950s academic researchers began to search for “efficient” portfolios of stocks and found that the most efficient portfolio was the market itself.”
Passive investing is appropriate for most investors, especially for beginner investors, and offers the following advantages:
- Better average performance than active management over the long term;
- Fees on index funds are generally lower and more transparent than on active funds;
- Superior diversification since the passive investing cover the whole index;
- Transparency and simplicity: As John Bogle of Vanguard wrote, “there is no point in looking for a needle in a haystack, you are better off buying the whole haystack”.
In practice, the renouncement to active management as an investment approach is one of the most important decision that an investor will make concerning a portfolio in order to improve diversification, reduce costs and avoid non-market risks resulting from active management failures, such as wrong stock picking, manager incompetence and a higher risks of failures and fraud. Choosing a reputable indexed offering such as Vanguard or iShares enable to reduce those risks.
Even if the markets are not perfectly efficient, the recommended investment strategy is to consider them as sufficiently efficient and follow a passive strategy. This is currently the best available cost-effective approach for retail investors.