FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
April 11, 2023

IN THIS ISSUE:

1. Pros & Cons Of Passive Vs. Active Investing

2. Passive Investing: What It Is & How It Works

3. Active Investing: What It Is & How It Works

4. Passive Vs. Active – Which Has Performed Better?

5. Best To Have Mix Of Passive & Active Strategies

Overview: Pros & Cons Of Passive Vs. Active Investing

For as long as I’ve been in the financial industry, which is over 40 years, there has always been a spirited debate over which is best: passive investing or active investing. The two approaches are very different, and most investment professionals have strong opinions on which is the best way to go.

Today, we’ll look at these two investment styles, how they work, how they differ and how they have performed over time. Many investors don’t know or pay attention to which category their investments fall into, and many diversified investors have investments which fall into both categories. It should make for an interesting discussion.

Passive Investing: What It Is & How It Works

Passive investing is a long-term strategy for building wealth by buying securities that mirror stock market indexes and holding them long term. It can lower risk because you’re investing in a mix of asset classes and industries, not an individual stock, and typically employ some form of dollar-cost averaging. Passive investing is designed to match, not beat, the market.

The essence of passive investing is a buy-and-hold strategy, a long-term approach in which investors don't trade much. Instead, they purchase and then hang onto a diversified portfolio of assets — usually based on a broad, market-weighted index, like the S&P 500 or the Dow Jones Industrial Average, among others. The goal is to replicate the financial index performance overall — again, to match, not beat, the market.

The most common passive investing approach is to buy an index fund, whose holdings attempt to mirror a particular or representative segment of the financial market.

Passive investing is the opposite of active investing, a more vigorous strategy which attempts to take advantage of shorter-term trading opportunities by timing the market. This approach may offer the potential for greater gains, , but usually has greater risk and volatility.

Passive investment strategies don't try to outperform or "time" the stock market with a constant stream of trades, as other strategies do. Instead, passive investing believes the secret to boosting returns is by doing as little buying and selling as possible. 

Passive investing is a thoughtful, time-honored philosophy which holds that, while the stock market does experience sometimes large drops and significant bumps along the way, it inevitably rises over the long haul.

This investment philosophy would suggest the best course of action is to mirror the market in your portfolio — usually with investments based on indexes of stocks — and then hold them for a long period of time. 

Thanks to its slow and steady approach and lack of frequent trading, transaction costs (commissions, etc.) are typically lower with most passive strategies. While management fees charged by funds are unavoidable, most exchange traded funds (ETFs)  Offer very competitive management fees.

Simple to understand and easy to execute, passive investing has become the go-to approach for many investors. 

There are thousands of passive mutual funds and ETFs which are widely available to investment professionals and individual investors alike.

Active Investing: What It Is & How It Works

Active investing means investing in funds whose portfolio managers select investments based on an independent assessment of their worth -- essentially, trying to choose the most attractive investments. Generally speaking, the goal of active managers is to “beat the market,” or outperform certain benchmarks.

Active fund managers assess a wide range of data about every investment in their portfolios, which may include quantitative and qualitative data about securities to broader market and economic trends. Using that information, managers buy and sell assets to capitalize on short-term price fluctuations and keep the fund’s asset allocation on track.

The active investor has the potential to move to a defensive position, such as cash or government bonds, during down markets in an effort to limit losses. Keep in mind, however, that moving partly or fully to cash means there is the possibility that you won’t move back to a fully invested position before the market resumes its long-term uptrend, thus resulting in returns which are below the market averages.

With active investing, investors can also reallocate to hold more equities in rising markets. By responding to real-time market conditions, they may be able to beat the performance of market benchmarks, like the S&P 500, at least in the short term.

Expanded trading options. Active investors can use trading strategies such as hedging with options or shorting stock in an effort to outperform market indexes. These also, however, can increase the costs and risks associated with active investing, thus making many investors avoid them in favor of lower cost passive investments.

A savvy financial advisor or portfolio manager can use active investing to execute trades that offset gains for tax purposes. This is called “tax-loss harvesting.” While you can certainly use tax-loss harvesting with passive investing, the amount of trading that takes place with active investment strategies may create more loss-harvesting opportunities.

Higher fees. Most brokerages don’t charge trading fees for run-of-the-mill purchases of stocks and ETFs these days. But more sophisticated, derivative-based trading strategies may incur more fees. And if you invest in actively managed funds, you’ll have to pay higher expense ratio fees.

Passive Vs. Active Investing – Which Has Performed Better?

For years various studies have typically shown that passive investing outperforms active investing. While there are select years when active investing outperformed passive investing, passive investing has been the clear winner over longer periods of time.

This is primarily due to the fact that passive investing, generally speaking, is always fully invested in the stock market, and the market has moved significantly higher over time.

Active investing in general lags because it is sometimes not 100% invested or can be out of the market altogether. As a result, it does not always catch all of the market’s upside movement.

Another reason passive investing often outperforms active investing is because indexes of passive investing represent portfolios which are 100% invested at all times in broadly diversified positions – whereas active investing include thousands of strategies – including both the successful strategies and the poor performing strategies.

But that doesn’t mean investors who prefer active management strategies, which can move partly or fully to cash in down-trending markets, are doomed to underperform passive investing. There are active management strategies which can outperform their passive counterparts. You just have to know where to find them, and many investors are just not equipped to do that.

Personally, I prefer carefully selected active management strategies over passive strategies for one primary reason: I prefer to attempt avoiding big losses that passive investments inevitably incur in bear markets. Stocks have declined by over 50% twice in the last 100 years. And there’s no reason to think it won’t happen again at some point.

While the market has always recovered from such losses and gone on to new highs, many investors don’t have the stomach to ride out such severe losses. Older investors may simply not have enough time to wait for a recovery from such severe losses as they have to start drawing down their assets to fund their retirement.

Conclusions – Best To Have Mix Of Passive & Active Strategies

For most investors, it is wise to have a mix of both passively and actively managed strategies in their portfolios. Passive investments ensure you are in the market at all times to catch all of the upside – even though that means being willing to hold on through severe downturns and even bear markets.

It is important to keep in mind that there are passive investments which have done well over time, but there are some which have performed poorly. So it is important to do your research and select only those strategies which are in alignment with your specific investment objective and tolerance for risk.

Most investors would also be wise to include some actively managed strategies in their portfolios. Successful active management strategies have delivered upside in the markets, while also helping to limit losses during downtrends and bear markets by moving partly or fully to cash.

37 Years Married To My Best Friend

Finally on a personal note, Debi and I just celebrated our 37^th wedding anniversary. We met in the workplace in Dallas in 1982 and quickly became best friends; we remain best friends today. In 1986, we founded our own money management firm which eventually became Halbert Wealth Management as we know it today. Debi is the Chief Financial Officer of Halbert Wealth Management.

We have two adult children who are both happily married, and we have three grandchildren so far. We live on beautiful Lake Travis outside of Austin, Texas. After all these years we still enjoy living and working together and more recently being grandparents. Our kids both live in Texas so we get to see them quite often.

I’ve lived a very blessed life and am grateful for many things. One of the things I am most grateful for is our business and our hundreds of loyal clients around the country. Thank you for supporting me for all these years and know that I’m always here if you ever want to talk.

Best personal regards,

Gary D. Halbert

Gary's Between the Lines column:
Retirement Age May Increase To 70 – Implications

 

Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc., a Registered Investment Adviser under the Investment Advisers Act of 1940. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of the named author and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific advice. Readers are urged to check with their financial counselors before making any decisions. This does not constitute an offer of sale of any securities. Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have their own money in markets or programs mentioned herein. Past results are not necessarily indicative of future results. All investments have a risk of loss. Be sure to read all offering materials and disclosures before making a decision to invest. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.