There is a great deal of misperception about the merits of passive vs. active investing.
The Difference Between Passive and Active Investing
First, let’s define terms for people who are not familiar with investment styles. Passive investing is buying all the stocks in an index, like the S&P500. Since there is no research involved and the only time an index fund makes a change is when there’s a change in the index, costs are kept low. Active investing, on the other hand, means that a fund manager looks at the stock market and buys those stocks he thinks will go up and avoids those that he believes will go down. Obviously he won’t be right all the time, but if he’s a good manager his selection will result in a fund that will do better than average.
That’s a simple explanation. It doesn’t get into factors such as value vs. growth, risk adjusted returns and other nuances. But it’s the basic concept.
Much is made about expense ratios and average returns. A lot of this confusion is the result of marketing by John Bogle, the founder of Vanguard Funds who made a fortune by promising his clients that they would never do better than average … and that was a good thing.
So why didn’t investing legend Warren Buffett give up stock picking and put his money in an index fund? Because he’s a good stock picker who can add value and get a better return on his money than a stock index. And Buffett isn’t the only one.
Comment from Oppenheimer Funds.
Indexing clusters investment assets in securities which represent past success, are widely owned, and often fully valued. Investing is about the future. Good active investors are adept at uncovering future success. Compounded over a long time horizons, the difference in so called “terminal wealth” can be very large between passive approaches, average active approaches, and above average active approaches.
Translation: Most indexes, like the S&P 500, represent the best performing stocks of the past, not necessarily the best ones to own in the future.
There are money managers who can add value to a portfolio, a better risk-adjusted return than the market. And there are managers who do worse. Knowing the difference requires years of research and expertise. That is what we at Korving & Company provide to our clients. We create a diversified portfolio of mutual funds tailored to the needs of our clients using funds managed by individuals who have demonstrated that they can add value over and above an index.
Without that, many investors are better off being average.