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Active vs Passive Investing

Posted on May 30, 2020 in Personal Finance

Active-vs-Passive-Investing

What is Active Investing

Active investing is where you either pick stocks on your own or pay someone else(say portfolio manager) to pick for you for your investments.
Your goal is to make your investment perform better than overall market by predicting which stocks will perform better.
If you know what mutual fund is, It is an example of Active investment. Fund pays Fund Manager who will do research and buys stocks for the fund.

What is Passive Investing

Passive Investing is where you buy entire index (like S&P500) to get same returns as the index. If index gains 10% in a year, so does your investment.
When you buy ETF like TSX:VFV, you buy piece of 500 largest companies in US.

Why Passive Investing is better?

Fees
Most of the Active investment charges higher fees (In the range of 1.5%-2.5%). It is the cost associated with salaries and bonus for fund managers,
cost of buying and selling shares, cost of research. Where as Passive funds such as TSX:VFV charges just 0.09% in fees.

Let’s see how fees impact your long term return over 20 years on the investment of $10,000.
Provided both Active and Passive funds give 6% per year, Let’s say Active fund charge 2% in fees and Passive fund charges 0.1% in fees.
Active fund will fetch you $21,911
Passive fund will fetch you $31,471
Fees will erode nearly half of the investment return.
I hear you, How come Active fund with expert fund manager perform same as Passive fund. It should be more right? that brings us to next point.

Performance
Only 14 of Active funds were able to make more than index, Even then it’s not consistent, Active Fund which performed well this year might make less next year.
Fund managers can go wrong with their predictions, It might be totally out of their control such as current Pandemic, Trump’s tandrum tweet or CEO’s scandel.
Here is an interesting read Cat Beats Professionals at Stock Picking
As Economist Burton Malkiel’s words in his book A Random Walk Down Wall Street, share prices move completely at random, making stock markets entirely unpredictable.
Even now, in mid of Pandemic with more than 20% unemployment, Stock markets are acting like everything is fine. Any fund manager who sold the stocks thinking stock market is going to crash would have missed the stock price increase we had over last month.

Interested in knowing about Vanguard Passive ETFs, read here