While both passive and active investors want to make money, they have fundamentally different views on the best way to do that.
Active investors believe that they can exploit the market by buying and selling mis-valued assets and attempting to profit when those assets change in price. Active investors charge higher fees for the work they do researching and strategizing how to buy and sell.
Passive investors, on the other hand, generally don’t believe that there are under- or overvalued assets of which they can take advantage. They believe that the market, which decides how assets are priced, is “efficient” – i.e., right. And if you believe that the market is priced correctly, then you can’t beat the market, and it’s expensive and time-consuming to try. As a result, passive investors believe that the best thing you can do is “hold the market”.
Passive investors tend to make fewer transactions, and don’t try to anticipate how the stock market will change. They invest in a broad variety of industries and company sizes, which creates a ‘diversified’ portfolio, and they usually hold those investments for the long term. Because there is less work down in this ‘buy and hold’ strategy, passive investment managers can charge lower fees.
Statistically, most active investment managers fail to beat the market, and when you add in their high fees, clients usually come away with even less than they might have with a passive strategy. In a cautionary tale that began in 2006, Warren Buffett made a bet with Ted Seides, a former co-manager of Protege Partners, that he could earn a greater return by ‘holding the market’, with an initial $1 million investment. Meanwhile, his rival attempted an active strategy to ‘beat the market’ with the same amount of money. Ultimately, the passive strategy paid off and, after 10 years, Buffett’s fund had increased by 85.4%, while Seides’ increased by only 22%. Seides conceded before the end of the bet.
The market is vast, so a common way to ‘hold’ it is to hold an index fund, which is a fund based on some subset of market companies. The S&P 500, one of the most common indices, is made up of 500 large, public American companies from different industries. Its diversification makes it a good base on which to create an investment portfolio, which many have done by creating mutual funds and ETFs (exchange traded funds) that mimic the makeup of the S&P 500.
OpenInvest does that too, building individual portfolios for each of our customers that reproduce the characteristics of the market, without the rigidity of those mutual funds and ETFs. We believe that low-cost, long-term investing is often the best option for the average investor as they prepare for retirement and the future. In the past, if you wanted to avoid investing in things such as weapon manufacturing, you had to rely on an active manager to keep you out of the companies you cared to avoid in order to stay aligned with your values. This often meant higher fees and a hit-or-miss performance. Fortunately, OpenInvest technology now gives clients the best of both worlds – the opportunity to strive for good return achieved through passive investing, from a diversified, values-based portfolio.
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When considering investing, please remember that no return is guaranteed, and people should only invest when they would be able to sustain losses.