What Is Active Investing?
Active investing is a strategy that investors
use when trying to beat a market or appropriate benchmark.
Active investors commonly engage in picking stocks,
times, managers, or styles. As later steps demonstrate,
active investors who claim to outperform a market also
claim the power to predict the future. When accurately
measured, this is simply not possible. Surprisingly,
the analytical techniques that active investors use
can best be described as qualitative or speculative.
They include predictions of future sales and earnings
growth, and are often based on gut feelings and intuition.
On the other hand, the passive index investing approach
is best described as quantitative or scientific. Indexing
techniques include statistical analysis of risk and
return data of twenty years or more, in addition to
extensive measurements of numerous performance criteria.
Many indexes are now based on seventy-five years of
risk, return, and correlation data.
What Is Index Funds Investing?
As opposed to active managers, investment
managers of index funds are far less active in the buying
and selling of stocks, because they do not pick stocks
or managers, time markets, pick styles, or make attempts
to forecast the future. As previously mentioned, the
analytical techniques that index funds managers use
are best described as quantitative or scientific.
Approximately seven percent of all individual
assets and thirty percent of all institutional assets
are currently invested in different index funds. Many
institutional funds are one hundred percent indexed.
Even Charles Schwab and Company recommends that investors
put eighty percent of their large cap assets into index
funds. Mr. Schwab himself has 75% of his mutual funds
in index funds. Other indexing proponents include Barclay's
Global Investors, Dimensional Fund Advisors, The Vanguard
Group, Warren Buffet, Peter Lynch, numerous academic
institutions, Economic Nobel Laureates, and Index Funds
Advisors (IFA). Insurance companies use a similar approach
to indexing when setting premiums for the risks taken
by insuring against thousands of different random events.
Most of those premiums are also invested in index funds
while held in reserves for the inevitable claim payment.
Most investors believe that index funds investing means
investing in familiar market indexes, such as the Standard
and Poor's 500. S&P 500 funds are structured with
the aim to provide the same investment performance as
the S&P. By holding all the stocks in the same proportionate
amounts as the S&P index, the fund index represents
about eighty-six percent of the market value of all
U.S. companies, mostly large blue chip stocks. The problem
is that market indexes, such as the S&P 500, were
not originally designed as investment vehicles.
Since the late 1980's, index funds have expanded and
are based on more discrete customized indexes. Originally
designed for very large pension funds, institutional-style
index funds are meant to capture various financial risk
factors or dimensions of the market. Exposure to a risk
factor such as company size or value constitutes a risk
dimension of the market. Investors have been compensated
with higher returns for risk exposure to these risk
factors since 1929. These dimensions of the market can
also be referred to as indexes. Indexes are groups of
stocks that have common risk and return characteristics
and comply to specific and clearly defined sets of rules
of ownership. These groups of stocks include companies
from the United States, foreign companies, and even
emerging markets. There are additional indexes within
these markets, such as value, large value, small growth,
large growth, real estate securities, and many fixed-income
investments, such as short-term and long-term treasury
bonds, municipal bonds, and corporate bonds. Companies
are purchased and held within the index when they meet
the index parameters. Stocks are sold when they move
outside of these parameters and no longer meet the index
rules.
An example of an index fund is Dimensional Fund Advisors'
(DFA) Micro-Cap index fund, which invests in securities
of U.S. companies whose size (market capitalization)
falls within the smallest 4% of the total market universe.
This includes all stocks traded on the New York Stock
Exchange and the American Stock Exchange, as well as
those listed in the National Association of Securities
Dealers Automated Quotation Over-the-counter (NASDAQ
OTC) market. Another example would be DFA's Small Cap
Value Fund, which invests in companies ranked in the
lowest eight percent by size, as well as the highest
twenty-fifth percentile by book-to-market ratio (value).
DFA funds are now available to individual investors
through a small qualified group of registered investment
advisors who have demonstrated their understanding and
commitment to the concepts described in this 12-Step
Program.
The overwhelming majority of investors are active investors.
Extensive research by many academics and investment
professionals has shown that investors cannot beat a
market in the long run with stock, time, manager, or
style picking. It is disconcerting that about seventy
percent of all institutional money invested in U.S.
stocks is still actively managed.
Active Investors are Everywhere
Over ninety percent of investors are
active investors. The most popular strategies in attempting
to beat a market include stock, time, manager, and style
picking. Steps 3, 4, 5, and 6 describe these strategies
and explain the futility of all these methods.
Stock pickers try to pick winning stocks rather than
diversify their portfolio.
Market timers, or time pickers, try to make money off
timing the markets. They think they can strategically
pick specific times to get in and out of a market, believing
this approach is more profitable than a buy-and-hold
strategy. Time picking also refers to the purchase or
sale of individual stocks.
Manager pickers buy stock portfolios or mutual funds
managed by the money managers who seem to have the best
recent performance record.
Active Investors are Gamblers
Active investors are deluded
that they are in control. They believe they have a special
understanding of the market, a superior edge over less
knowledgeable investors, and that they are immune to
disaster. The truth is that all investors can access
the same information as professional money managers
through the Internet and many other sources. Still,
many investors believe they are smarter and more sophisticated
than the average investor. Those under this illusion
fail to realize just how much investment performance
depends on luck. Most of them eventually pay dearly
for this mistake.
read
more |
