Active vs Passive Investing

by | | Investing

Active vs Passive Investing

There are two main ways that fund companies approach investing: active and passive.

Active managers hire an expensive research team to pick if Coke or Pepsi will do better. In this way, they hope to “beat the market.”

Passive managers just buy Coke and Pepsi. Lower overhead means lower costs for investors. You win!

The overwhelming majority of academic evidence supports passive investing over active. Here’s just one example.

The Arithmetic of Active Management

We nerds here at ER Doc Finance love math, and math shows that passive management wins.

The total market return is the sum of the returns achieved by passive investors and active investors.

Total Return = Passive Return + Active Return

Now assume 30% of investors are passive and 70% are active.

Total Return= (30% x Passive Return) + (70% x Active Return)

Now assume the total return is 10%. Passive investors are simply buying the entire market, so their return is also 10% before costs.

10% = (30% x 10%) + (70% x Active Return)

It follows that the active investors’ return is also 10% before costs.

10% = (30% x 10%) + (70% x 10%)

So passive and active investors both got 10%, right? Not so fast. We said before costs!

Assume average cost of 0.2% for a passively managed fund and 1.0% for an actively managed fund. After costs, Jane Passive got 9.8% and Joe Active got 9.0%!

OK, we’ve seen that if a passive manager and an active manager have the same return before costs, the passive manager will win. So why don’t we just find an active manager who’s above average? Someone who can “beat the market?”

Identifying Above Average Managers is Hard

To win with active management, you need an active manager who is above average by enough to offset their higher fees. This is very difficult to do. Over the 5-year period ending December 31, 2020, only 25% of mutual fund managers beat their benchmark after fees (source: SPIVA® Scorecard).

So why don’t we just buy the 25% that outperformed in the past, and let them outperform in the future?  That strategy is likely to fail too. On average, only 21% of stock funds that outperformed over the previous 5-year period outperform again over the next 5-year period (source: DFA 2021 Mutual Fund Landscape).

25% past outperformance x 21% future outperformance = 5.3% total outperformance

Those aren’t good odds!

What Does This Mean for Me?

If you’re an emergency physician committed to evidence-based investing, you’ll take a passive approach to your investments. This means choosing low cost, index-like funds in your portfolio and not trying to “beat the market.”

Can’t tell if you’re investing in active or passive funds? Our FREE Financial Pulse Assessment™ includes an investment analysis! We’ll analyze your investments and comment on how you can make improvements. Check out the link above or click here to schedule your Financial Pulse Assessment™ Intake Call.

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