The small or unsophisticated investor loses money for a number of reasons. Here are three:
(1) poor asset selection, (2) poor timing, and (3) excessive fees.
Poor asset selection refers to the tendency to invest in assets which are riskier than initially assumed. Often, novice investors chase financial instruments which have exhibited fast price appreciation in the recent past. This fast appreciation is evidence of high risk. Inevitably, over time the higher risk is realized in the form of fast price declines.
Poor timing refers to the tendency to under-invest in stocks when these are undervalued (investors buy too few cheap stocks), and to over-invest in stocks when these are overvalued (investors buy too many stocks which have already peaked and are destined to decrease in value). Poor timing often occurs because the novice investors watch as stocks appreciate in value, and eventually become worried that they will lose out while everyone else appears to be benefiting. Finally, they decide to ‘go for it’ and buy the now significantly appreciated stock. All too often, their decision to purchase is made just around the time the firm falls out of favor, leading to steep price declines and big losses.
Excessive fees are often paid by novice investors. Unknowingly, they accept investments with relatively high fees when very similar investment vehicles are available at lower cost. Higher fees dramatically undermine wealth accumulation over extended periods of time.
Often, passive investment strategies are the best frameworks for avoiding poor asset selection, poor timing, as well as excessive fees.
Wednesday, July 22, 2009
Thursday, July 16, 2009
Passive versus Active Investing Styles
Passively Managed (Indexed) Mutual Funds
Passively managed or indexed mutual funds are created by acquiring the stock of all firms meeting certain criteria. Often, the only or most important criterion is membership in a broadly diversified index reflecting an overall market's movements. Examples are large cap indexes that try to match the S&P 500 index or an index of the largest firms traded on the NASDAQ exchange. Because the managers of passive funds don’t need to expend time and money researching individual stocks, they incur relatively low costs and can make their funds available to investors with relatively low expenses.
Passively managed mutual funds are typically characterized by:
Actively Managed Mutual Funds
As the name implies, the stocks or bonds that make up a particular actively managed fund are individually or actively selected by the funds’ management team. The team often applies a variety of criteria in the selection, beginning with very detailed fundamental analysis of individual stocks or bonds. Only those instruments that meet the requirements are selected. Active managers believe they have the ability to identify and buy stocks or bonds that are relatively undervalued and then sell them once they appreciate in value. The proceeds from those sales are then used to buy other stocks or bonds that appear undervalued. The deep analysis required prior to each transaction, along with the frequent buying and selling of instruments means higher expenses for the management team, and these expenses are passed on to the investors. Thus, actively managed funds exhibit higher fees than passively managed ones.
Actively managed mutual funds are typically characterized by:
Active funds are only appropriate if the investor believes the fund's management team has the ability to select stocks that subsequently appreciate and simultaneously sell stocks that subsequently depreciate. While it's tempting to believe that managers have this ability, the rigorous academic literature has repeatedly found that few managers appear to be able to identify winners and losers consistently, and even those few who appear to show such consistency, may simply have been lucky over an extended period. This observation, combined with the higher expenses associated with Actively managed funds, implies that most investors are better off relying on Passively managed funds.
Passively managed or indexed mutual funds are created by acquiring the stock of all firms meeting certain criteria. Often, the only or most important criterion is membership in a broadly diversified index reflecting an overall market's movements. Examples are large cap indexes that try to match the S&P 500 index or an index of the largest firms traded on the NASDAQ exchange. Because the managers of passive funds don’t need to expend time and money researching individual stocks, they incur relatively low costs and can make their funds available to investors with relatively low expenses.
Passively managed mutual funds are typically characterized by:
- high degree of diversification
- low transaction costs
- low management expense ratios
- minimal taxes
- appropriate for long term investing
Actively Managed Mutual Funds
As the name implies, the stocks or bonds that make up a particular actively managed fund are individually or actively selected by the funds’ management team. The team often applies a variety of criteria in the selection, beginning with very detailed fundamental analysis of individual stocks or bonds. Only those instruments that meet the requirements are selected. Active managers believe they have the ability to identify and buy stocks or bonds that are relatively undervalued and then sell them once they appreciate in value. The proceeds from those sales are then used to buy other stocks or bonds that appear undervalued. The deep analysis required prior to each transaction, along with the frequent buying and selling of instruments means higher expenses for the management team, and these expenses are passed on to the investors. Thus, actively managed funds exhibit higher fees than passively managed ones.
Actively managed mutual funds are typically characterized by:
- high portfolio turnover
- high transactions costs
- high management expense ratios
- higher tax liabilities
Active funds are only appropriate if the investor believes the fund's management team has the ability to select stocks that subsequently appreciate and simultaneously sell stocks that subsequently depreciate. While it's tempting to believe that managers have this ability, the rigorous academic literature has repeatedly found that few managers appear to be able to identify winners and losers consistently, and even those few who appear to show such consistency, may simply have been lucky over an extended period. This observation, combined with the higher expenses associated with Actively managed funds, implies that most investors are better off relying on Passively managed funds.
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