A guide to understanding investment philosophy for small business owners
There seems to be an ongoing debate in the investment landscape regarding two contrasting investment philosophies: passive vs. active investing. I will provide details about the definition of each philosophy and the benefits and drawbacks of each investment approach. Since there are benefits and drawbacks to both philosophies, note that there are investors who use more of a hybrid approach, which is combining active and passive investment strategies. Whether a small business owner chooses a passive or active approach with their investments (e.g., retirement account), the key is still for them to stay aligned with their long-term financial goals by maintaining an appropriate asset allocation and understanding their personal risk tolerance. Additionally, it is important for a small business owner to have the same investment philosophy as their financial advisor because a mismatch in this area would most likely cause problems in the client-advisor relationship.
Passive Investing
Definition
Passive investing can be defined as constructing an investment portfolio that has an objective of matching the performance of a specific index (e.g., S&P 500 Index) instead of trying to outperform it. Passive investors will invest in mutual funds or exchange-traded funds (ETFs) that track (either exactly or approximately) a specific index meaning that there are no (or minimal) decisions to make about which investments to choose (i.e., buy for, keep in, or sell from portfolio). This results in less frequent trading and lower research costs, which is why management fees are lower with passive investing.
Benefits of passive investing
The primary benefit of passive investing is its lower costs compared to active investing. A lower cost structure can result in higher net investment returns over a long-term period. Expense ratios (i.e., internal costs) can be described as the operating expenses of the vehicles (e.g., mutual funds, exchange-traded funds, index funds) used by a financial advisor to construct an investment portfolio. As indicated, passively managed funds have lower expense ratios than actively managed funds. I provide an example below that shows how lower costs can significantly benefit a retirement portfolio in the long term. Note that for illustration purposes, both options assume only having one investment fund in the portfolio, no additional contributions, and have the same average rate of return over time.
Option 1: $100,000 initial investment, 0.3% expense ratio, 8% annual return
Option 2: $100,000 initial investment, 1.3% expense ratio, 8% annual return
Option 1: Annual return after deducting expense is 7.7%
Option 2: Annual return after deducting expense is 6.7%
Option 1: Investment value after 25 years is $638,841
Option 2: Investment value after 25 years is $505,953
Another benefit of passive investing is its simplicity as it is an easy strategy for an investor to understand since the objective is to track a specific index.
Drawback of passive investing
A drawback of passive investing is its lack of flexibility. Since the objective is to track an index, passive investing does not adjust based on market conditions or economic changes. For example, if a particular sector in the market was experiencing losses from underperformance, a passive investment strategy would not react quickly to mitigate these losses.
Active investing
Definition
Active investing can be defined as constructing an investment portfolio that has an objective of outperforming the performance of a specific index. Active investors focus on research and analysis, which provides more flexibility to adjust portfolios based on market conditions and capitalize on opportunities. This results in more frequent trading and higher research costs, which is why management fees are higher with active investing.
Benefit of active investing
The primary benefit of active investing is its flexibility, which leads to the potential to obtain higher investment returns. An active investing strategy provides flexibility to adjust portfolios based on current market conditions. For example, if an active investor identifies a downturn in a particular sector of the market during a time of extreme market volatility, then they can quickly adjust their portfolio to mitigate losses.
Drawbacks of active investing
The primary drawback of active investing is its higher costs as an active investing strategy has higher management fees than a passive investing strategy. As a result, these higher fees can have a negative impact on investment returns, especially in the long term.
Another drawback includes the risk of underperformance. Although an active investing strategy maintains the potential for an investor to achieve higher investment returns by outperforming a specific index consistently, data shows that a significant percentage of actively managed funds actually underperform over the long term.
Investing philosophy at Lasting Wealth Principles
At my firm, Lasting Wealth Principles, I use a passive investing philosophy as I believe that my clients should focus on keeping their investment fees low. Even further, I focus on making sure my clients understand their personal risk tolerance and have an investment portfolio with the appropriate asset allocation.