At the beginning of every year I have a little routine.
I take the time to grab a cup of coffee, sit down in front of Vanguard’s website, and review all our current and potential investments.
Exciting? I know … But it has to be done.
What is it I’m looking for exactly? Obviously the opportunity to make more money!
More specifically I’m combing through the performance figures and seeing what’s out there.
But wait! Aren’t I just wasting my time? I thought all the “smart” investors just buy a simple index fund that follows the S&P 500? That’s the big secret behind active vs passive investing, right? Set it and forget it! Couldn’t I just do that instead?
Well, I could …
… but is that really the smartest thing to do?
What Are Active Funds Trying to Do?
Actively managed mutual funds are not always quite the villainous used car salesmen that people make them out to be. The whole reason they exist is because a fund manager somewhere believes he/she can achieve valuable goals that a regular index fund would not ordinarily accomplish.
What might those goals be?
- Higher returns
- Diversification mixture
- Exposure to markets that the S&P 500 doesn’t reach (i.e. foreign)
- Exposure to other asset classes (small-cap, mid-cap, etc)
- Other kinds of assets (bonds, cash, etc)
- A certain investment strategy or philosophy that the manager believes in
- Investments in companies that fit a certain type of philosophy
And my personal favorite:
But John Bogle Says Passive Funds Are Better!
“Hold on a minute!”
“You can’t say it’s okay to invest in an actively managed mutual fund?”
“That’s financial blasphemy!”
“Plus it goes against what all the cool personal finance bloggers say!”
This is a long standing belief between active vs passive investing has long been advocated by many professional and amateur investors alike. The theory was made popular by the founder of Vanguard John Bogle. In his book “The Little Book of Common Sense Investing“ as well as other publications, Bogle widely supports the advantages of using passively managed index funds over actively managed ones.
While he makes some valid points, I think of the things that often gets misinterpreted in Bogle’s message is this:
An actively managed fund will never be able to beat the long-term returns of a passively managed index fund. (FYI – Depending on whether you follow the Dow Jones or S&P 500, that figure is somewhere between 8 and 10% per year).
Where Active vs Passive Investing Can Make a Difference:
Suppose we Bogle’s statement to be true. Suppose I DON’T CARE to beat this 8 to 10% figure, and I accept that is the maximum average return I could ever hope to see. So what then?
You pick your investments based on two criteria:
- How big of returns we get net of expenses
Notice how the Bogle’s statement above doesn’t say anything about the risk or security of those funds. What do I mean by that?
Everyone knows that stocks (as well as all investments to a degree) go up and down. Sometimes the price shoots up really high. Sometimes the price drops down really, really low. That’s the risk you take on as an investor.
So if we know that our returns are “fixed” at this upper limit of 8 to 10%, then which would you rather have (assuming both come out the same in the end):
- A fund that fluctuates widely up and down?
- A fund that fluctuates modestly up and down?
If you said No. 2, then you’re with me. And you need something more than a passive index fund.
Why Defense Matters:
You might ask:
If both funds end with the same returns, then what does it matter? After all – aren’t we all supposed to be investing for the long term?
Yes, that’s true.
All of this largely depends on your investment horizon. If you have 30 years or more to invest, then who cares which one you invest in.
But let’s look at a very real scenario.
Suppose you retired tomorrow and needed to start making withdraws from your money. If you have a million dollars and use the 4% rule to withdraw money, then you’ll get $40K. And you’ll expect to withdraw an inflation adjusted $40K every year thereafter.
But wait! Oh no! The stock market crash of 2008 happened all over again and your investments dropped by 50%! Now your million dollars in savings is only $500K. If you continue this $40K, now you’ll be withdrawing 8%! And that’s surely going to drain your savings!
So now you’re stuck with risking sabotaging your savings or reducing your living expenses by half! Neither of these are very good.
That’s where a defensive strategy could have been beneficial. Say instead of dropping by 50%, your accounts only dropped by 25%. While that’s not great, you’re in a much better position than you were with a 50% drop in savings.
But I’m not planning to retire for a long time! So who cares?
That also may be true. But don’t underestimate the psychology of money.
How do you feel when you see a 50% drop in your 401k? Good? Or like you want to jump off a bridge?
I remember in 2008 when stocks crashed so many of my co-workers decided to move all of their savings into cash investments. “Better to preserve what we have left than to lose it all” was their logic – even if it was flawed.
So why torture yourself? If you can find funds that have the same returns as passive funds, but carry less risk and fewer fluctuations in prices, then I say why not!
Consider one of my favorite balanced funds: The Vanguard Wellington Fund (VWELX) versus the S&P 500 index. Though the Wellington fund is made up of both stocks and bonds whereas the S&P 500 is all stocks, both have similar returns. But take a look at these returns and tell me which one you would feel more comfortable with:
Notice how the Wellington fund return is much more steady than the common stock index. If you were retired, your money would have greater potential to not run out. Even if you’re not retired, you’d probably freak out a whole lot less when your fund doesn’t decrease by as much as everyone else’s.
Thus you can see there would be some benefit to using an actively managed fund.
You Be the Judge:
This post should not be interpreted as saying that all passive funds are bad or that all active funds are better. Rather this post is simply trying to get you to think a little differently about active vs passive investing.
You can bet that passive funds will still play a very important role in my 401k fund! Why? Because when I look deeper into all the actively managed funds offered by my employer, I’m not impressed. The passive one beats most of them.
But remember – it’s up to you how you want to build your investments. If you have no problems with the risk or see no reason to stray, then pick the passively managed fund. But if your investment strategy or tastes call for something a little bit more defensive, then don’t be afraid to look beyond the plain vanilla flavor of an index fund. It could mean the difference in thousands and thousands of dollars later on in life.
Readers – Where do you weigh in on the active vs passive investing debate and why? Do you see how in some instances an actively managed fund might actually help more than it hurts your portfolio?
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