Can I buy that hot stock? Active vs passive investing in the stock markets

If you have been asking yourself that question because you have been reading about a hot stock that has been experiencing a ridiculous increase lately, and wish to cash in on it, you are not alone. A lot of people want to buy a stock or a set of stocks because they see people becoming overnight millionaires. When you decide to pick certain stocks and invest in them, you are what is called an active investor. Huh? What else is there? Well, the opposite of active of course! It’s called passive investing! 🙂 Today, I want you to go down a walk with me to not just understand what active and passive investing theoretically mean but also to help figure out what kind of an investor you want to be. There are lots of debates and opinions out there. As always, I will not tell you what you should do but I will do my best to give you an informed opinion to make your own decision. 

Active vs Passive investing

So let’s get some basic understanding here. When you actively pick stocks to buy, you are an active investor. The other way you can be an active investor is to outsource your active stock picking to a professional. There are funds out there where you have fund managers who actively pick stocks to invest in the funds and if you buy into those professionally managed funds, you have purchased an active fund. So what does passive investing mean? Well, a passive investor is someone who does not wish to pick stocks but is going to invest in a fund that simply tracks a market index. Now what does that mean? You may have heard about the S&P 500 index in the US. That’s a list of the top 500 publicly listed companies in the US by market capitalization (it’s a fancy word to describe the value of the company based on the value of their shares. At a basic level, the math is share price * number of shares outstanding). So a passive investor instead of ‘hiring’ a fund manager to pick stocks, simply says he/she is just going to pick a fund that consists of pre-picked stocks (like the S&P 500) and will earn whatever returns those stocks provide. 

An active fund manager typically has a team of research analysts to research the different stocks, and is generally trying to get better returns than the average market returns. Since they have a fair amount of costs and overheads, these funds cost more. Generally an active fund can charge around 1% of the amount of money you invest. This is called the expense ratio of the fund. A passive fund on the other hand does not need to do any research whatsoever because they simply invest in ‘pre-picked’ stocks based on the index they track. So these are pretty inexpensive and they have expense ratios ranging from 0% to 0.2% of the total amount you invest. 

I just want good returns so why do I care if it’s active or passive?

That’s a very good question and there are a couple of things to consider here. 

1. If you are investing by picking stocks by yourself, then ask yourself if you have access to or the ability to develop the same kind of research that active fund managers have to make these decisions. If you don’t, then how are you deciding which stocks to invest in? If your reasoning is anything from “I love their products” to “Everyone is doing it and making tons of money”, then you are going down a dangerous path and I would strongly advise you against it. I will explain more in a bit. 
2. Net returns after expenses – Say you decide to invest $10,000 in an active fund. The returns from this fund is 10% and the expense ratio is 1%. Then, your net return is 9% ( because you parted with the 1% to your fund manager as part of the expenses). Now, what if I told you you could have earned the same 10% in a passive index fund with an expense ratio of 0.1%. Then your net return is 9.9%. You just lost 0.9% in returns by investing in the active fund. What if the passive investment returns were even better than the 10%?? That would be even more of a no-brainer. 
3. So the final question you may have is – so do I make better returns from active or passive funds? Well, there is nobody who can answer that in a definite way. What we can say is that the research seems overwhelming that a majority of the passive index funds actually outperform the active ones. I will provide more detail on that further in this article. 

Ultimately you should care about your ability to make better returns after all expenses. 

What happened to the old mantra ‘Buy low, sell high’?

When I started working many years back, this was the advice I was given. Make sure you buy at a low price and sell them when they are at their highest point. It made perfect sense to me at that time. I was like, this is simple. A few years back I decided to dabble in investing in stocks. I decided to invest $10,000. How did I pick the stocks?  Well, I simply looked around my house and thought of all the great consumer products I use and thought – I buy these so these must be companies doing really well. After I bought them, I was waiting to see when I could sell them to make a quick buck. Almost a year passed and I was frustrated by how they had hardly moved. I realized my first obvious mistake – how on earth was I supposed to when the high point or the low point for the stock was? Maybe if I was Nostradamus and could predict the future, I could do this. As I started reading to figure out how people were picking stocks, my head reeled at all the different analysis professional stock pickers would do. I mean I got my MBA so I had to be pretty smart right? Wrong! Not only did I not know how to do all the analysis the professional stock pickers did, I also did not have the patience to do so. I sold those stocks in frustration and moved it back to my checking account that earned a solid 0.1% interest. Wow – talk about money mistakes. 

If the lesson above was not obvious – let me make it explicitly clear. There are people who pick stocks for a living. That’s what they do day-in and day-out. I am not even in their leagues. I dont understand a lot of things they talk about. They invest the time understanding the company, the industry they operate in, a lot of them analyze their financials to understand how healthy they are. And guess what? They still dont do better a lot of times than investing in a passive fund! So ask yourself what kind of an investor do you want to be? 

What about those guys who invested in some of those hot stocks and made a ton of money? 

They certainly did not have all this research and analysis done before buying them? You are correct – they did not. They were just plain lucky. Ooh! That’s a cop-out answer! Actually it’s not – there is nothing more dangerous than an investor who made a quick buck out of a hot stock and starts to think his/her strategy is sound. They got lucky once – it does not mean they will get lucky again. Not unless they have a sound strategy. If they don’t, then I call it going to Vegas and gambling with your money. 

In early 2021, there was a ton of press around the meme stocks, the YOLO (You only live once) crowd who get together on Reddit forums and make a killing buying stocks. Without going into painful details, I will simply say this – that’s a classic “I read about this stock. Let me buy it. Oh, looks like everyone is buying this and the price seems to be going up.” The only outcome in all those situations is ultimately those stock prices come crashing down (because there was no logical reason for it to go up in the first place) and the lucky ones cash out, and the unlucky ones are left holding the bag. This is not a strategy – this is just FOMO (fear of missing out) investing which is probably the worst form of investing. 

Ok what about that guy named Warren Buffett?

Yeah I have heard of him. The oracle of Omaha. What about him? Are you wondering how he made all his money? Old Warren has a couple of things going for him that you may not realize. So let’s get the record clear here:

• Warren Buffet is the ultimate buy and hold investor. His famous saying is that his holding period for stocks is FOREVER. That’s right – he does not want to ever sell the stocks. Buffett says if you don’t feel comfortable owning a stock for 10 years, you shouldn’t own it for 10 minutes. Popular behavioral finance columnist Morgan Housel explains that the reason Warren Buffet really made his money was not because he was exceptional at picking stocks but because he has been a buy and hold investor for 80 years! Remember what I have explained about the power of compounding? But not all his buy and hold investments have panned out. But you know what – he can afford to take a few hits. He’s got a few extra dollars in the bank to cushion himself. 
• When Warren Buffett typically invests in a company – he either just buys them or simply takes a large stake in them. He might take an active role in the company or have strong influence on having good people run the company. Again, he has made his share of mistakes. Remember the investment in Heinz? He had to write off $3B – small change for old Warren.

So no, don’t compare yourself to Warren Buffett. But listen to his advice for the everyday investor. I am going to quote directly from his famous 2013 letter to Berkshire Hathaway shareholders as to what he has put in his will for his money for his wife upon his death*:

“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

Mic drop! I guess I could simply end here. But I want to highlight a couple more things. 

Are you telling me passive funds do better than active funds?

Yes and No – There are tons of active funds out there. I even have friends working for some of them who probably are not liking this article very much. There are certain spots where active funds in the long run have done better than passive funds. But for most parts, the statistics are fairly overwhelming. Passive funds tend to outperform the active funds significantly. Don’t take my word for it. There is research that supports this. 

But why is that? Why can’t highly educated and professional companies beat the market consistently compared to a standard passive fund? Let me introduce you to a final concept called ‘reverting to the mean’. This is an age old statistical concept. While there is too much to unpack in this, I will over simplify it here for the purpose of this article – it simply means active fund managers cannot consistently beat the market every single year over a long period of time. Ultimately, everyone has to revert to the mean – or to put it simply will move to the average. Moving to the average involves doing worse than the market in certain years. This is the basis for the Efficient market hypothesis. For those who are really captivated by this want to geek out, you can learn more about this here: https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp . 

So what should I do?

As I conclude, I will simply say this – depending on your goals as an investor, you can choose to be an active or a passive investor in the stock markets. I choose to be a passive investor for all the reasons I have detailed in this article and therefore invest a 100% of our stock and bond investments in broad market based index funds only. I would argue for the average investor, that is a far superior strategy. If you are really interested in learning more about this, I would encourage you to read Burton Malkiel’s book, ‘A Random Walk Down Wall Street’. He makes a compelling case for index funds and certainly one of the books that has influenced my own investing strategy. 

No article on active or passive investing will ever be complete without an ode to Jack Bogle, the late founder and CEO of the Vanguard Group. He has done more for the average investors like you and me than anyone else and was the one who pioneered low cost index funds. I love his famous quote that epitomizes index investing –

“Don’t look for the needle in the haystack. Just buy the haystack!” 

Jack Bogle, late founder and CEO of The Vanguard Group

Thank you for reading and I wish you luck in your financial journey!

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.

*https://www.berkshirehathaway.com/letters/2013ltr.pdf