So, you’re ready to start investing, but have no idea where to begin? You’re not alone. As you start charting your course to becoming the next Warren Buffet, one of the first questions you’ll need to ask yourself is whether you’re more of an active investor, or passive investor? If you have no idea what that means, don’t worry, we’re going to break down everything you need to know about active versus passive investing, and help you assess which route is best for you.
Defining active and passive or ETF investing
Let’s lay down the groundwork with some key definitions.
- Active Investing - this is an approach to investing where you pay someone (i.e. a portfolio manager) to buy and sell individual stocks. Typically done through a mutual fund, an actual human being looks at economic trends, financial statements, and other information to make informed decisions on what will get you the highest possible return on your investments.
- Index - this is a collection of stocks that are being tracked to help measure how well a certain market is doing. Think of this as a Grade Point Average that allows you to compare your performance to that of your classmates. Except, instead of grades the index compares companies within a specific market.
For example: The S&P 500 is a common index that assesses the 500 largest listed companies in the US. It is used to track how well the US economy is performing. Basically, it’s checking the pulse of the economy.
- ETF Investing - this is an approach to investing where you place your money in an index instead of having a portfolio manager buying and selling for you. This is usually done by an algorithm on an online platform. Typically, if you see words like “robo-advisors,” “ETFs,” or “index funds,” it’s a passive investment.
Comparing the pros and cons of ETF and passive investing
Now that you have a better understanding of what these two approaches are, let’s figure out which type of investing works best for you.
Like most personal finance strategies, neither route is necessarily ‘better’ or ‘worse’ than the other. Each has benefits and drawbacks that you will need to assess based on your personal lifestyle and goals. To make that exercise easier for you, let’s look at the pros and cons, or benefits and downsides to each investing approach.
- One of the biggest perks, and biggest draws for passive investing is that it’s cheaper than active investing. By opting for this route you can potentially save tens of thousands of dollars in fees over your lifetime. This is because active investing requires you to pay higher fees to account for the human being that is actively managing your mutual fund or investment portfolio, as opposed to an algorithm that’s been developed to make your trades and manage your risk. Having a dedicated portfolio manager provides a more tailored approach, which naturally would come with higher fees. Unfortunately, Canada is notorious for having some of the highest Management Expense Ratios, or MER fees than other comparable countries.
- Less of your time is required to manage and assess your portfolio. Because passive investing follows an index, you typically expect a very similar return as the index. You’re riding the waves of the market, so you go with the flow of how the economy is doing. It’s like taking a skytrain to your destination. You can expect a fairly consistent time of arrival at your destination from when you enter the train. Similarly, passive investing gives you a fairly consistent return over time. Taking the skytrain means you’re not preoccupied with driving a car. You can use this time and to focus on things that matter to you!
- In general, passive investing outperforms active investing in the long-run. This debate has been going on for decades! Fortunately, there are many people much smarter than us who did all the heavy lifting with researching and crunching the numbers. Over a period from 2005 to 2020, over 80% of active funds underperformed their respective indexes. This is just one of many sources that consistently show that passive investing has a higher likelihood of getting you a higher return over the long run.
- There is a possibility of a higher return as an active investor. Back to the skytrain example, the active investor is trying to find a shortcut to get to their destination faster. They might take a car, a taxi, a motorcycle, or a boat. They use their best judgment to see if they can get to the destination faster than the skytrain. An active investor (or the portfolio manager they hire) uses their best judgment to try and get the highest return they can. The tradeoff is that the returns can vary greatly. A taxi might get you to your destination faster, but there might be unexpected traffic!
- Having a professional to review your investment portfolio can provide peace of mind. Some people would gladly pay a premium (a higher MER) to know a portfolio manager is looking over their investments. If you find yourself losing sleep or obsessing over if you made the right investment decision or not, it might be worth considering a professional to help you feel confident with your investments. You can work with a financial coach to help educate you to feel more confident with investment decisions (yes, this is a shameless plug to book a free call). However, if you would prefer to delegate your investments entirely, you can find a financial advisor or investment advisor who can set you up with an investment plan. If you are just getting started, they will usually recommend mutual funds that are actively invested. Just make sure you know how your advisor is getting paid!
- If you want more control and flexibility over specific investments and industries, active investing might be more appropriate for you. You can buy all Disney and Tesla stocks, only technology companies, or only in European companies. You’re pretty much a kid in a candy store and you can choose whatever candies you want with the money you have.
As always, the choice is up to you. Only you will know what type of investor you are. Do you prefer to be more hands-on and take control of the steering wheel and be more active with how you get to your destination? Or do you prefer to go with the flow, focus on what’s important to you, and let the waves passively take you to your destination?