Debating the merits of active vs passive investing has got to be one of the favourite – and entertaining – pastimes in the FIRE community.
Clearly, the default stance is that passive beats active by a stretch.
At the same time, take a closer look at many “passive” portfolios and you will find more than a pinch of active investments inside.
Certainly, my own portfolio is no exception.
10% in two single-name banking stocks (though a big chunk is soon to be liquidated).
Another 46% in small-cap and value stocks.
One aspect I’ve always found fascinating about the active vs passive investing debate is that it’s nigh impossible to get to an objective answer.
Sure, empirical evidence suggests that passive will beat active.
But most active investors shoot right back and claim that they are the ones who bucked the trend.
Off the top of my head, I can think of at least six challenges in trying to determine which strategy is better.
There’s the issue of measuring returns. Not hard in principle – all you need is the timing of cash flows, an excel spreadsheet, and an XIRR formula.
And yet, if I was a betting man, I would wager that very few active investors have a proper system for tracking their returns.
The same applies to investing in funds. As Ben Carlson pointed out in this piece on Peter Lynch:
During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return.
But Lynch himself pointed out a fly in the ointment. He calculated that the average investor in his fund made only around 7 percent during the same period.
When he would have a setback, for example, the money would flow out of the fund through redemptions.
Then when he got back on track it would flow back in, having missed the recovery.
Assuming you’ve got the returns part figured out somehow, there’s also measuring risk.
In other words, what is the standard deviation of your returns? Did you take on more heartburn than needed?
Show me an individual active investor who calculates a Sharpe ratio for their portfolio and I’ll show you a unicorn.
Got the risk box ticked as well? Well, how about measuring luck?
Was your outperformance a result of skill, or an individual case of the infinite monkey theorem?
And that’s before you get into things like time horizons (i.e., will your outperformance persist) – or the fact that if the active money management sector keeps shrinking, generating alpha will get much easier.
A Better Way
If you can figure out a way to address all of the points above, I’d love to hear from you in the comments section.
But in the meantime, I would venture to say that agonizing over which strategy is better might well miss the point.
Instead of debating the merits of active vs passive investing, it’s far more productive to focus on actual investing.
Your savings rate, which has a far greater impact on your portfolio than your returns:
Investing early and often.
Diversification – especially for active portfolios.
Minimizing fees. Returns come and go, but fees are always there.
Making some investments that pay you every month.
Most importantly, consistency. Once you’ve zeroed in on a strategy, give it sufficient time to compound.
It’s a bit like jumping on a flight to Hawaii.
You can go direct – or choose one with a layover. There may be tailwinds or headwinds along the way.
Heck, you might even find yourself on an unscheduled stop along the way.
But the most important thing is to board that flight in the first place.
The sooner you’ll do it, the faster you’ll arrive.