In our last post we covered the mechanics of buying shares and how you go about getting started with share investing.
Once you’ve got the basics down, you’re doing great. But, you then need to figure out what shares to buy! This is probably the most important decision you’ll make as an investor, and if you get this wrong, you’re going to struggle to make the progress you should, and you could end up suffering setbacks and costing yourself a packet – a massive momentum killer!
A big part of your decision here is about the sort of investment strategy you want to follow. When it comes to choosing how you’re going to invest, there are two main styles you’ll come across. Make the wrong decision here, and you can run into serious trouble. But get this right, and you’ll be well on your way to investment success.
We are talking about investment styles here. How you choose the investments you put your hard earned money in, and how your money will grow over time.
But what does this all mean?
Active investing means, as the name suggests, your investments are managed ‘actively’. What this really means is that you are choosing investments that you think will do better than all the other investments out there. You are trying to choose the investments that will perform strongly. This normally involves a ‘fund manager’ running calculations, trying to figure out which companies will and won’t perform well, choosing more of them, and avoiding companies that will experience average performance and those that will go backwards.
In short, the active investor assumes they can do better than all the other investors by choosing the best companies to invest money in.
Passive investing on the other hand involves investing in the overall market. In contrast to active investing, instead of trying to pick the best performing investments, you invest a small amount in the overall market (all companies). Once you do this, you are certain to get the average return of the market you’re investing in. This is a more simple approach, as all the information on the companies is publically available, so it’s easy to replicate the overall market.
So to condense, the passive investor invests to achieve the return of the overall market on the assumption this will perform better than choosing individual investments.
So which is better? And what are the risks?
The risk with active investing is that the investments you choose don’t perform as expected. Because these investments are chosen by humans, and the fact there is no secret formula to predict the future and choose the best companies, this is a very real risk.
The downside of following a passive investment strategy is that by investing in the market, you won’t be getting the huge returns that are possible when you invest all your money into one or a few investments. But in this case you also reduce the risk of investment failure if you don’t know or aren’t able to select the investments that will shoot the lights out at the time you’re investing. Think about how much risk you want to run in your strategy here to establish what sort of investment strategy is going to be best for you.
The other risk with passive investing is that you don’t replicate the market correctly, which is really a non issue as this can be done by computer programs these days that do this almost perfectly. Because the market is replicated almost perfectly by a computer program, you are almost guaranteed to get the market return every time. This means that the risk becomes losing out because you could have invested with a good active manager.
There is data to back up the fact active investors don’t perform as well as they make out. Vanguard in their Case for Index Fund Investing paper written last year found that 72% of active fund managers failed to outperform the market over a 10 year period. This shows the risk of active investing, where you run the very real risk of the person making your investment decisions getting their decisions wrong, and you suffering the consequences.
We’ve already talked about the fact that when you have time on your side you don’t need to take a bunch of huge and unnecessary risks.
When advising client’s I favour a passive approach, as this reduces almost all investment risk other than timeline risk (coming in our next post). This investment strategy produces stable, tax effective, long term returns, and cuts out most of the risk of underperforming as you know you will get the market return over time.
Take the time to get your investment style right for your strategy now, what you want from your investments, and the amount of risk you’re prepared to run in your strategy. If you do you’ll reap the benefits as you get ahead. You’ll also increase your sleep at night factor by knowing you’re not making a bad call that’s going to cost you down the track.