Active management and passive management are two contrasting investment strategies. Active management is based on the idea investors can outperform the market through security selection and market timing. Passive management is based on the idea investors cannot consistently outperform the market. The passive strategy holds that efficient markets make excess gains too expensive to pursue, so investors should aim for average performance at minimal cost. Both investment strategies have valid arguments, but an evaluation of each method will show why the passive investment strategy is the more favorable option.
The active investment strategy presents some challenges. The first challenge is determining which securities to own. For example, when an investor wants to own a mutual fund in a particular category, the investor must select among hundreds or thousands of available funds in that category. The selection process is usually based on an evaluation of how mutual funds in that category have historically performed, and the investor will typically select an actively managed fund that has performed well in the past. The problem is past performance does not guarantee future results. The investor can select a actively managed mutual fund that has performed well in the past, but that fund could be among the worst performing funds in the future. Mutual fund managers cannot consistently beat the market, so consequently, investors risk underperforming the category with an actively managed fund.
The passive investment strategy does not require such an in-depth evaluation and comparison of different securities. When a passive investor wants to own a mutual fund in a particular category, the investor selects a low-cost, well-diversified index fund that represents that category. An index fund does not have as much risk of underperforming the category because an index fund should represent the same composition as the category. In each category, some securities will perform well and some will perform poorly, but when they all net against each other, the result will be average market performance. The passive investor is willing to accept average market performance rather than accept the risk of underperformance. Past performance of an index does not guarantee future results, but if an investor wants to perform as well as the category index, then an index fund will typically produce those results.
The second challenge of the active investment strategy is knowing when to own certain securities. The active investor wants to own more aggressive securities when the market will perform well and more conservative securities when the market will perform poorly. To determine how the market will perform, the investor must evaluate the current environment and make predictions for what will happen going forward. The problem is that investors' predictions and timing are not always right. Investors have a tendency to buy securities when they are performing well and sell securities when are performing poorly, when actually, they should do the opposite. Some investors know to buy low and sell high, but they must still make predictions for when the lows and highs will occur. The investors' predictions may be right sometimes, but in order to outperform the market, they must accurately predict the market a majority of the time.
The passive investment strategy does not attempt to time the market by buying and selling different securities based on market conditions. The passive investor would prefer to follow a buy-and-hold approach utilizing a diversified mix of index funds. First, investors determine their appropriate asset allocation based on their risk tolerance and time horizon. Then the investors select a mix of securities that represents their appropriate asset allocation and maintain that allocation through various market fluctuations by rebalancing occasionally. By rebalancing, the investors sell overperforming securities and buy underperforming securities, which is to follow the ideal principle of buying low and selling high. Passive investors maintain their current asset allocation through market fluctuations because if they are allocated appropriately, they are willing to accept the risks and rewards that come with that allocation.
The active investment strategy can outperform the passive investment strategy if an investor is fortunate enough with security selection and market timing, but the high costs of attempting to outperform make the active investment strategy impractical. The passive investor can buy and hold index funds with low expenses. The active investor will research and evaluate multiple securities and market conditions and select actively managed mutual funds with a higher expense ratios. Even with all of that effort and expense, active investors may still underperform passive investors, and even if the active investors perform as well as the passive investors, the additional costs incurred put active investors at a disadvantage. For active management to beat passive management, investors must consistently outperform the market average. Investors cannot consistently outperform the market, and in the times when they can outperform, the added costs negate excess gains. These are the reasons why the passive investment strategy frequently results in better performance.
