Imagine you have painstakingly saved up $100,000 and you’re all ready to invest for a brighter future ahead.
But you are undecided on whether to adopt a hands-on approach and invest in stocks, or, park it under passively-managed instruments like Robo-advisors or Index Funds.
After all, this has been a decade long debate between “active” and “passive” investing, and, you find merits in both the approaches too.
Today, we aim to explore deeper into the pros and cons of these 2 concepts and introduce a better alternative which you may have missed out on.
The Concept of Passive Investing
A passive investment strategy can be referred to as a more hands-free approach where you aim to buy into an instrument and just hold the investment for the long term.
One common example is to invest in Exchange Traded Funds (ETFs), where they mirror the performance of an entire market index (i.e. you can buy SPDR S&P 500 ETF to mimic the price and yield performance of the S&P 500 Index).
Based on the chart below, you would have made $4 for every $10 invested just by buying the ‘market’ and holding it for 3 years – a hassle-free approach.
The underlying principle of this strategy is that markets are efficient and that all available information has already been priced into the market.
Thus, if the market cannot be beaten, people should simply aim to buy the entire market as a whole, and focus their efforts on reducing transaction costs and fees.
With all that said, let’s zoom into the pros and cons of a passive investment approach.
Passive Investing: Pros and Cons
Passive investing is a style that is excellent for people who:
- Have no time
- Have no expertise
- Do not wish to devote the time or the effort to learn about the stock market
As previously mentioned, passive investing is far less time and effort-intensive endeavour than its active counterpart.
That means that the work required to earn the average market return is kept to a bare minimum – buying and holding an index is a process that can be automated with a regular shares savings plan.
There’s no need to spend hours researching whether a company would do well in the next 10 to 20 years.
To add on, you can avoid paying exorbitant fees charged by advisors or hedge funds simply by buying the index as a whole.
Another advantage of passive investing is the diversification that comes through when buying an entire market index.
You are literally diversifying into a portfolio of 500 stocks when you buy a single share of S&P500 Index ETF!
Achieving this level of diversification would prove almost impossible as you are required to buy a single share of 500 stocks at one go – leading to immense commission charges which defeat the purpose of ‘matching’ the index return in the first place.
While the above seems to make a strong case for a passive approach, the largest downside is the fact that your returns are capped at the market return and you have to be sure to pick the right market to follow.
The effects can be far-reaching when you take the fact that the STI Index has barely broken even on the price returns over the last 5 years while the S&P 500 has delivered above 50% returns during the same period of time.
With that said, let’s hop over to the other side of the coin – Active Investing.
Active Investing: The Concept
Active investing is a far more work-intensive but supposedly more rewarding strategy.
The underlying principle of active investment management is that the stock markets are irrational (because people are irrational) and there exist pockets of “inefficiencies” which active investors can exploit.
These market inefficiencies allow active investors to achieve market-beating returns.
In fact, Warren Buffett led Berkshire Hathaway to generate an average stock price gain of 20.8% per year from 1965 to 2017, more than double that of the S&P 500, and – he’s not the only person to do it.
This is literal evidence that beating the market is possible.
In other words, being an active investor means you are constantly on the lookout for opportunities to market-beating returns.
Active Investing: Pros and Cons
Let us start off with the primary drawback of active investing – it takes a lot of time, and outperforming the market is not guaranteed.
In fact, the average investor may still end up with unsatisfactory returns as seen below.
With that in mind, why do people still choose to actively pick stocks?
In my honest opinion, I think active investing is split into two distinct camps:
The 1st camp is trying their luck to beat the market.
These are the people who may have little to no set framework, little to no ability to read financial statements, little to no ability to analyse a sector or industry, and little to no ability to analyse a company’s durable competitive advantages.
They typically rely on broker tips, newsletters, stock recommendations and analyst reports – most of which have been proven over time to be deleterious to their wealth.
The 2nd camp is filled with people who have devised, or, adopted a strategy which has the odds stacked in their favour to beat the market.
Typically, these are the people who retain their wits and logic about them and try not to let money (an emotional topic) get in the way of investing (a process best without emotions).
These second camp of investors typically spend anywhere between 3-12 months to build up a reliable base of evidence-backed investment methodologies before even buying their first stock.
That is because they know once they have passed the first learning curve, the rest is simply constant, but minimal learnings.
As astute investors, we believe the 2nd camp is the way to go.
Many notable investors like Warren Buffett, Benjamin Graham and Seth Klarman have advocated value investing and successfully beat the market over a long period of time.
Hence, there is always the possibility of retail investors beating the market if they follow a tried-and-tested investment strategy.
That is also provided that they spend the time and effort to do due diligence and monitor the markets.
But what about combining the best of both worlds?
What if you could beat the markets, and still spend the least amount of time possible to do it?
Factor-Based Investing: A Framework Based on Data and Evidence
Welcome to the world of Factor-based investing – a viable alternative to both passive and active investing.
Factor investing is a mechanical approach using factors that have been proven to outperform the markets for the past 30-40 years.
The 5 of them include:
- Momentum
- Profitability
- Size
- Value
- Beta
Side Note: To know more about the factors, you can check out a comprehensive guide here.
Back to the point, these factors have undergone rigorous statistical tests with decades of data as a validation process.
The various findings remain consistent: factor investors win well consistently over time.
In fact, according to a book (Your Complete Guide To Factor-based Investing) written by Larry Swedroe and Andrew Berkin, they back-tested a multi-factor portfolio comprising various factors in their book.
They found that any combination of Factors performed better than a single Factor alone as shown in the table below.
Conclusion
In a nutshell, Factor-based investing bridges the gap between active and passive management – achieving market-beating returns, whilst minimizing effort and costs through following a rules-based investment strategy.
Personally, this is the perfect approach for a retail investor who is in search of higher returns but who do not have the time or energy to devote hours and hours of work to investigate the nitty-gritty of each potentially good company.
You can read all about factor-based investing and its evidence here.
Some of the reports can be found here and here, and additional resources can be found here. Foundations of factor investing can be found here. The factor investing book we recommend you to read can be found here.
Factor investing is, as you can tell by now, a well-backed, well-researched, evidence-driven approach.
In our eyes, it is perhaps the most sensible, mature way of approaching individual stock selection, that gives you the best chances of beating the markets.
Obviously, going through all of the above is going to be somewhat time-consuming, but I can promise that you will be better off for it.
If and only if you don’t want to spend months reading, learning, then applying it yourself, and instead you want to learn directly from us, you can also do so by registering for a seat here.
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