If you’re new to investing then you might be confused about how it exactly works. Perhaps you’re vaguely aware that it involves setting money aside regularly over a long period (e.g. 10+ years) into companies, funds and other assets which causes your net worth to grow. You’d be right, but how does investing lead to wealth growth?
Broadly speaking, there are two main approaches to investing, often referred to as ‘active’ and ‘passive’. In this short guide, we will be explaining the difference between the two, and outlining WMM’s reasons for primarily advocating the latter approach when it comes to constructing an investment portfolio for our clients.
We hope you find this guide helpful, and if you have any questions about your investments then we invite you to get in touch to arrange a free, no-commitment consultation with one of our financial advisers here at WMM.
Active & Passive: An Overview
When you put your money into a UK deposit account, it wasn’t too long ago when you used to be able to expect a reasonable return earned via interest; in some cases as high as 6%. Today in 2019, however, you’re lucky if you can find anything close to a 2% interest return. When you factor in the fact that inflation, at the time of writing, sits at around 1.7%, making any money at all on cash investments is difficult. Most people are losing money in real terms.
This situation has encouraged many people to consider investing, to increase their prospects of growing their wealth and retirement savings over the long term. However, most people do not have the confidence, experience, risk appetite or resources to invest “Dragon’s-Den-style” into individual companies. So what are your options?
For most people, the primary route available to you is to consider investing in “funds”. This essentially involves pooling your money together with other investors, which is then invested into multiple companies or assets. The investment returns are then distributed amongst the investors according to the amount committed as well as the performance of the investments.
For instance, suppose you invest some of your money in a FTSE 100 tracker fund (along with other investors). This fund follows the performance of the UK’s biggest 100 companies, and averages the shares of all of these companies to produce an index. If the index goes up, then your investment produces a higher return. If it goes down, then so does your investment.
This is the essence of “passive investing”, since it involves committing your money and “holding” it there to follow the index(es) you have chosen. It’s worth noting that a portfolio containing passive investments should really involve multiple tracker funds to spread out the investment risk (i.e. “diversification”), and the investor is in essence seeking to capture the ‘Market Return less costs’.
The passive approach to investing is quite different to the image many people have in their minds, when they think about investments. Quite often, the popular image is of a fund manager who spends every day investing in certain companies and pulling money out of others, to try to “beat the market” for clients. This is known as active investing.
Pros & Cons of the Approaches
Depending on your experiences, beliefs and background you might be more inclined towards active or passive investing. At WMM, we want to be fair in outlining the advantages and disadvantages of both approaches, but also put our cards on the table and state that, in general, passive investing tends to offer a higher likelihood of increasing a client’s net worth over the long term.
Here are some of the points in favour and against active investing:
Pros
- Active investing is often considered to be quite flexible, as you are not limited to a predetermined set of investments (as you tend to be when picking tracker funds).
- Active investing has shown some prominent cases of generating strong success stories for their clients. For instance, in 2013 Apple dropped to less than $60 per share. Many active fund managers anticipated the dip and invested clients’ money into Apple whilst it was low. By 2017, Apple has risen to $150 per share.
Cons
- Investment management fees tend to be higher with active fund managers. These fees can significantly eat into an investor’s returns over the long term.
- Even the best fund managers struggle to consistently beat the market over many years. In fact one study by the Pensions Institute showed that between 1998-2008, only 1% of active fund managers produced returns which overtook their costs.
Let’s now consider some of the pros and cons of passive investing:
Pros
- As mentioned, passive investing tends to carry lower expenses than active fund management, which tend to lead to more money in investors’ pockets. The lower cost is generally because a tracker fund does not need to employ an active fund manager to buy and sell stocks each day.
- Passive investing mainly follows index trackers, which represents the aggregate wisdom of millions of investors regarding the share value of the companies concerned. By and large, this means that the true value of most companies’ shares is already priced in. This makes financial markets in the developed world quite robust, meaning it is harder for active fund managers to get an edge. This allows the passive investor to potentially benefit from long-term growth without needing to constantly monitor their portfolio.
Cons
- Passive investing is, by nature, more of a “buy and hold” approach to investing, which can sometimes lead to missed opportunities which might be open to the active investor (think of the Apple example above, between 2013-2017).
- Sometimes passive investors can become complacent, adopting a “set and forget” approach to their portfolio. This is dangerous, as even a predominantly passive investment portfolio will need to be reviewed at least once a year to ensure everything is still on course towards its investor’s financial goals.
This article is for education, inspiration and information purposes only. It was intended to explain common Investment approaches in a very simple light. In fact, the term ‘passive’ is an often misused term covering certain investment funds which are to an extent actually ‘active’ but for specific reasons. Therefore this basic content should not be taken as investment or financial advice. To receive regulated, tailored financial advice regarding your situation, or to find out more about WMM’s investment philosophy then please contact one of our financial planners.
