Passive vs Active Investing:
As we mentioned before, active investing involves a manager (really a team) picking stocks that will grow faster and greater than others. Over short periods of time, many managers do this extremely well and make their investors a lot of money. However, study after study has shown that over long periods of time, more than a few years, these managers suffer losses that cancel out their previously stellar returns.
For individuals like us, how would we know who to pick year by year, when to leave them, and whom to trust next? These managers charge fees that eat into your returns and add up to tens, if not hundreds, of thousands of dollars over time.
Mutual fund managers charge a fee for their services. This is called an expense ratio. It is taken from the money that you invest in the mutual fund. This can be anywhere from 0.05% to more than 2% per year. So if you invest $100 in a mutual fund with a 1.0% expense ratio, the manager will take $1, even if your money doesn’t grow in value. Only 99 of your dollars will ultimately be invested.
Then, whether your money grows in value or shrinks, he will take another 1% the next year, and the next year after that, as long as he’s investing your money for you. Naturally, we hope that by investing in an active fund, the manager will make our money grow larger than it would in an index fund by a margin larger than the expense ratio, but statistically speaking, it doesn't over long periods of time.
This is possibly the most important area through which we guide you on this website. The difference in cutting out an expense ratio is worth hundreds of thousands of dollars. In Invest! we walk you through exactly what you can do about cutting out fees, taxes, etc.
Passive investing, on the other hand, is investing that keeps up with the market. A passive portfolio is made up of index funds that track indexes like the S&P 500. The passive managers of an index fund don’t spend time and money handpicking stocks they hope might turn out to be winners. Instead, their funds hold every stock in the index, proportionally, and adjust when the index adjusts.
By choosing a passive approach, you will pay extremely low fees and neither underperform nor outperform the market. This means that over long periods of time you can reasonably hope to earn a return of about 8% a year by holding a portfolio mostly made up of stocks-- for us, that means index funds. There will be months and years when you lose money, which is OK because there will be months and years where you earn much more.
You don’t need to gamble on a stock that you or someone else thinks will be a winner. You can simply buy the market, diversifying away the risk associated with investing in individual companies. Because you pay such low fees (easily less than 0.20%), you actually outperform the herds of investors who pay exorbitant fees for active management and find the long-term results severely disappointing.
The graph below shows that cutting out just 1% in fees can amount to an extra $150,000 after 40 years!
The difference after 20 years in the above graph would be $12,906; after 50 years, it would amount to a whopping $403,708! It can be worth more than a million dollars in situations where the investor contributes more each month than the one in this hypothetical.
*This graph assumes an annual return of 8% before fees in both the active and passive portfolios. Returns are compounded annually and not adjusted for inflation.