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Is it smarter to actively invest or choose strategies that are more passive?

Is it smarter to actively invest or choose strategies that are more passive? © Brus_Rus via iStock

Entertainer Kenny Rogers may have inadvertently come up with one of the best pieces of investment advice ever when he sang, “You’ve got to know when to hold ’em, know when to fold ’em, know when to walk away, know when to run.”

We have in this space, in somewhat less colorful language than that sung by Mr. Rogers, sounded the same themes when it comes to investing, particularly the “hold ’em” part, or buy-and-hold, if you will. That is, don’t risk losing the game by trading the hand you have (your portfolio) for unknown cards (new investments) that may not perform as well. Not to overwork the metaphor, but playing poker and “playing” the market have another thing in common: They are usually going to cost you. Which of course begs the question: If active investing is a costly gamble, and, with low interest rates, fixed income investments are underperforming, what does work?

Remember the old axiom, “Leave well enough alone”? Well, there is one investment product that does exactly that, and more often than not actually outperforms active investors: index funds.

When the markets recovered after 2008, a colleague with a somewhat macabre sense of humor said, “The real winners were dead investors.” Point being that, given their situation, they couldn’t buy or sell anything, so they ended up back where they started, or often even ahead of the game. Index funds do not require that you “shuffle off this mortal coil,” but they do need you to leave them alone.

With index funds, by avoiding the temptation to buy what’s hot and sell what’s not, you avoid getting ‘wrong-footed.’

Most mutual funds are actively managed, meaning you consistently take “new cards” by picking stocks and trying to time the market. In contrast, index funds are what some call passive investing. The way that works is this:

You and your advisor construct a portfolio that matches, or tracks, one of the market indexes, like the S&P 500, let’s say. As its name implies, the S&P includes 500 stocks, some of which can go up, and some down; but by tying your “index” to this broad sweep of investments, you may minimize your portfolio’s exposure to the volatility of the market. Another important reason index funds may end up on the positive side of the ledger: Like a good reliable paid-for car, they cost very little to run.

In simple terms, playing the markets costs money. But, if you utilize index funds, you keep costs low by keeping the management fees low and transaction costs virtually nonexistent. (Transaction costs include not only commissions, but the difference between the bid and the offer, which can be quite significant). Also with index funds, taxable events remain low. Meaning that you are off to a good start.

Additionally, with index funds, by avoiding the temptation to buy what’s hot and sell what’s not, you avoid getting “wrong footed,” since the market not only probably has discounted the good or the bad, but may have overly discounted it. So, good stocks are priced to perfection and bad stocks are priced to oblivion, neither of which is a likely outcome.

In sum, trying to beat the blended decision-making of potentially millions of investors can be a fool’s errand. That’s why just waiting it out and sticking to your plan is a way of not getting involved with the perceived need to be smarter than the market. In truth, the success of index funds lies probably more with their ability to help you keep costs low and avoid actively buying and selling than with the specific stock selection within the indexes.

But, whether you chose index funds or funds with low turnover and low costs, or buy and hold individual securities, the likelihood is that you will live to see yourself do well over time.

This article was originally published in the October/November 2016 issue of Worth.

Investing and the EconomyWealth Management

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