Active Versus Passive Investing

Here’s a little story. It’s a story of two seemingly different brothers who share a common job.

Cornelius was a rather astute and precocious child. He was a hard worker. Very analytical and Type A. He had to be right, so he spent hours and hours in his room researching and learning. He got a perfect score on his SAT and went on to get an MBA in finance and statistics. Cornelius started an investment company – he started a mutual fund where he focused on discovering, analyzing, and investing in large cap U.S. companies. He spent hours digging through their financials and would crisscross the country, meeting with the executives of the companies he was thinking about investing in. He had detailed spreadsheets and forecasts of the companies, their competitors, and the economy. He spent every waking minute buying companies he thought would do well and selling companies if he thought they would no longer do well. Every year, his mutual fund performance would be compared to other mutual funds and would be compared to a similar index. In his case, the index would be other large cap U.S. stocks. His fund would be scrutinized, and he worked more and more hours to do better than the other mutual funds.

https://youtu.be/_Ep1zYYDmZU

He had a whole staff of other analysts who did the same thing he did. They would look at 100 companies and select one or two to invest in.

You could say Cornelius was quite active in his approach – always analyzing and studying, and buying and selling.

His brother, Bodhi, was not quite as intense. Bodhi was more interested in surfing (you get extra credit if you can tell me the ‘90s movie with a surfer named Bodhi!). Sure, he liked to make money, but he also like to hang ten.

Bodhi saw the success of his brother, so he asked Cornelius for a job.

“You must be joking!” Cornelius retorted. “I would never hire you. You couldn’t even get your GED.”

Rejected and dejected, Bodhi decided to start his own mutual fund. He saw how hard his brother worked and the long hours he put in. Bodhi thought, “Man, if I work like him, dude, I’ll never catch another wave in my life. That’s bogus.” So, he decided his mutual fund would be a little different.

Instead of doing all that research, analysis, and flying all over the country trying to find the best companies, he would skip all that. Instead, he went in on January 2 (the market is closed for New Year’s Day) and simply looked at what an index with large cap U.S. companies had in it (all indexes will list what investments are in the index). He then bought those companies for his mutual fund. Then the next January 2, he would compare what he owned versus the index. Maybe the index replaced some of their investments with others. No problem. Bodhi would sell those and buy the new investments. It took him about 20 minutes every January 2. The rest of the year, he surfed.

Now, I don’t want to call Bodhi lazy. You might call him passive. He wasn’t trying to do all kinds of research and buy and sell throughout the year, month, or day. He just stuck with whatever investments were part of the index.

Cornelius was an active manager. In fact, his style of investing is called “active management,” for pretty obvious reasons. He was very active. He was trying to beat the market or the index.

Bodhi wasn’t trying to beat the market; he was trying to be the market.

His approach was passive. His style of investing is called “passive management.” It’s a bit like saying “jumbo shrimp,” though. It’s passive, but can you really call it “management”? He didn’t do much at all. There was little management, but whatever. That’s what his style of investing is called. It’s also referred to as index investing. Get it? He’s investing in an index.

So these are two very different styles. Why is it important to know about them?

It can get pretty expensive to hire all of those analysts and travel all over the country. Active investment managers are usually more expensive as a result. Compare that to the passive index investing approach. Very little overhead. Very few expenses.

Yes, but won’t Cornelius get a much better return because he’s doing all that research and analysis? Well, you’d think so and you’d hope so. And that’s definitely the promise of using an active manager. But, sadly, that’s not always the case.

And in the next lesson, you’ll find out why.

The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.