I recently wrote a post about the pros and cons of passive investing earlier in the week. Now I would like to take a look at active investing. Active investing is an investment strategy where the individual investor is more involved in the buying and selling of securities. Active investors believe that by managing their own money they can beat the return of the stock market.
Investing With Mutual Funds
The most popular investment for active investors is a mutual fund. The majority of funds sold by mutual fund companies are actively managed. Most retirement accounts and brokerage accounts are comprised of actively managed mutual funds. An actively managed fund is a fund where a manager regularly buys and sells investments. The active investor aims to outperform a specific stock market index such as the S&P 500 or the Dow Jones. A fund manager in an actively managed fund may re-balance the fund as frequently as once a quarter. Active investors believe that the stock market is inefficient and that they are able to benefit from its inefficiencies by purchasing securities when they are undervalued.
Let’s say you purchased a value fund. This fund would typically purchase out-of-favor stocks from different sectors that the fund manager believes are selling at a discount. Value fund managers like Bruce Berkowitz have found great success investing in highly distressed assets. Berkowitz has consistently outperformed the S&P 500 index over the last 10 years.
Investing With Individual Stocks
Individual stocks are another popular investment vehicle for active investors. One of the biggest proponents of an active investing strategy is Jim Cramer. Cramer’s philosophy is that the active investor should take control of their future by abandoning passive investments. Passive investors have a “buy and hold” strategy; active investors have a “buy and do homework” strategy. It’s called a “buy and do homework” strategy because active investors have to research their investments by reading and analyzing financial statements. Surprisingly enough, Warren Buffett is an active investor himself! That’s right, Buffett researches and actively invests in companies that he believes represent a compelling value. It’s important to remember that Buffett is an active investor not an active trader.
The Advantages of Active Investing
- Active investing allows investors to quickly take advantage of undervalued market sectors.
- Active investing provides the potential for greater profits and returns than the overall market and index funds.
- Active investing provides greater control over an investment.
The Disadvantages of Active Investing
- Active investing can have much higher management fees and expenses than other investments.
- Active investing can provide more taxable income, leaving you subject to more taxes.
- Active investing can underperform the market due to poor investment strategies.
So, which approach is best? A combination approach is the best option. Passive investing and active investing should have a place in every investor’s investment strategy.
- Start with an index fund or ETF. Index funds can be an anchor for your portfolio providing your portfolio with diversification.
- Add an actively managed mutual fund. Be sure you pick a good fund manager with a solid track record. Look for a fund with an expense ratio below 1%, low management fees and a smaller market cap. Once a fund’s market cap gets too big, it becomes hard for the fund manager to duplicate past returns.
Which strategy do you feel is the best approach? Do you consider yourself an active investor or a passive investor?
(photo credit: Ehnmark)