Sunday, July 19, 2009

Passive Investing Versus Active Investing

As one grows older, one’s financial needs change and evolve. Many financial experts and planners have advocated different allocations for one’s funds according to one’s age bracket, and this post is to discuss the options available to one as one ages and nears retirement (assuming this word actually exists in Singapore !). My thoughts had centred on the concept of passive investing, as defined by Benjamin Graham as the “defensive” investor; versus active investing, or the “enterprising” investor. I shall elaborate on the two concepts below and discuss the salient points for each as well as deliberate on the pros and cons.

Passive investing involves methods such as purchasing into index funds or buying blue chips which are “guaranteed” to survive recessions, and in Singapore’s context some examples would be SingTel, DBS and UOB. There is a lot less thought and analysis to be put into such decisions and in effect you are just “buying the market”, or coming close to that effect. Passive investors do not have to take the time and effort to devote to careful analysis of individual companies, and they also do not need to bother about under or over-valuation as they simply need to pick an index fund which tracks the long-term returns offered by being vested in equities. The idea of “passivity” is further extended to not really needing to keep track of one’s portfolio as one should be reasonably certain of favourable long-term returns, assuming one has not committed oneself during periods of irrational exuberance. Perhaps there ought to be a disclaimer here: one can only be reasonably assured of a decent return on investment through the passive method if one purchases during a recession or sharp downturn (as we are in now), where general price levels and valuations are low. If one makes the mistake of buying into index funds during periods of irrational exuberance, then it may still take many years before one can break even on their investment; passive though this strategy may be. Therefore, it is critically important for a passive investor to have some rudimentary knowledge of economics and stock market dynamics; as well as some general feel of market psychology, in order to ascertain a proper and conservative entry point. Perhaps some indications can be derived from the sentiments of the general public, where the herd normally stampedes, one may find it wise to act in a contrarian fashion. Note though that this method does not necessarily work for the active investor, as I shall elaborate below.

Active investing, as the name implies, literally means one has to get low-down and dirty in dissecting the numbers and analysing the facts, in order to delve deeper into the investment merits of individual companies. It’s a lot of hard work involving blood, sweat and tears; and the problem is after all the effort, one may still not be able to beat the indices and trump the “passive” method of investing. Thus, many argue – why bother to do all the analysis yourself when one can just get a market rate of return from buying an index fund ? Several reasons are offered for this:-

1) One’s age profile and time constraints - Index investing is suitable for those without too many family or personal commitments and who have time to visit companies to attend AGM, and also to pore through thick and boring annual reports to spot little known facts. If one has a family with 3 kids, suffice to say it may be better to rely on passive investing.

2) Knowledge and Analytical Skill – Let’s face it, some basic accounting knowledge is required to analyze financial statements; as well as skill in interpreting the numbers and having a holistic view of a company. Some people may not be properly equipped with such skills to undertake a rigorous study of a company; so they let analysts do this job. Passive investing may be more suitable if one does not have the proper skills.

3) Psychological Strain – Passive investing removes the emotions from investing as you just buy into an index fund or several well-established blue chip companies. Active investing requires some monitoring of the stock market to ensure one has a decent margin of safety and does not over-pay, and one also has to monitor in case one’s company becomes too over-valued, such that one may be compelled to sell and switch into another under-valued company. Such stock market monitoring would inadvertently place psychological strain on the active investor, and even though Benjamin Graham’s advice is to ignore Mr. Market, part of us which is human would still be unable to be completely detached from his emotional mood swings.

4) Satisfied with Market Return – For investors who are content with achieving a market rate of return, then they should be contented with passive investing as it achieves just that. Someone did mention that for an active investor, the reason why he is into active investing in the first place is the belief that he can achieve returns which are better than market averages. Otherwise, why bother?

With the arguments for and against passive and active investing, the question now is to ask oneself which method suits your skills, knowledge and temperament more. There is definitely no right or wrong and one has to select the style which suits him best. But please note that this discussion is just confined to investment in equities; I have not included other forms of investment such as unit trusts, bonds and derivatives.

For myself, as an active investor, it’s not just a matter of getting better returns than the market which drives me (and I have yet to demonstrably achieve this, by the way), it’s also the passion for analysis and my interest in reading up on companies which spurs me on. Investing is a constant journey of learning and it never stops till the day you pass on, which is why it makes for such an intruiging journey filled with ups and downs. Since I took up the value investing mantle, I have learnt so much more about companies and have increased my knowledge many times over compared to when I first started out in 2004 as a “newbie”.


Shingo T said...

I'm an active investor.

Its pretty fun trying to beat the index, though I may not neccessarily have achieve this. =p

musicwhiz said...

Hi Shingo T,

Haha yes I guess it's fun to try, but remember that capital preservation is still of utmost importance; so even if we fail to beat the index, we want to preserve capital and get a decent long-term return.


H said...

Hi MW!

Allocation between asset classes is important to me.

I overweight equities past few months and would rebalance next few months.

I am more a "passive" investor as I invest mainly in my checklist of companies, etfs and funds.

Some people measure their NAVs of assets yearly. It helps in rebalancing & examining the returns of each asset class.


musicwhiz said...

Hello HH,

Yes, true allocation is very important and we should all do so periodically. I am still learning how to re-calibrate my portfolio once in a while, either adding or taking out cash from the stock market (of course, with valid reasons to back me up).

Blessings to you too,

H said...

Hi MW,

I am still learning. Need to be more active.

Maybe u want to consider other asset classes beside cash and equitites.

I am building up commodities & one other asset in my portfolio.

For equitites I don't find it meaningful to keep focusing on prices when a good company is paying u good dividends unless its way way over-value and one can find a better company to invest in!(which is not easy!).

Its not even meaningful (for me) to look at how many folds that stock make now because it was thrown out irrationally in the first place.

For most of my companies, I am just happy with the % allocation except for heavily overweight of one property counter.

I like to accumulate and not sell. Selling is not easy.


musicwhiz said...

Hi HH,

I guess we are all learning, and becoming better human beings in the process. :)

I am also considering property but the time is not right yet because 1) I have yet to build up enough cash reserves, 2) I have yet to properly understand the property market and 3) Need more hands-on experience in surveying properties like visiting the physical sites.

I agree too that checking daily prices is not meaningful, except when I wish to average down. I accumulate on the slow and don't sell unless something fundamental crops up.


Daniel Baktiar said...

Hi musicwhiz,
Thanks for the articles that I really could enjoy.
Just to assert a bit, from what I read in 'Intelligent Investors' it seems that Graham preferred the terms 'defensive investors' vs 'enterprising investors'. Defensive investors shouldn't be passive at all. They still need to monitor the market, and also under/over valuation of the market.

Musicwhiz said...

Hi Daniel,

I think defensive investors can just buy an index fund and sleep soundly at night, so I don't think they necessarily need to monitor the market at all.