Broadly speaking, there are two investment strategies available to you: active and passive investing. While you may choose to change strategies or to manage two separate pools of money—one using each strategy—it is important to stay the course within each pool once you’ve committed to it. This is particularly important in the passive strategy which requires patience over a very long term. Active strategies are not appropriate for the vast majority of investors. I discuss them here only for the sake of completeness.
An active investing strategy is all about searching for undervalued securities (usually stocks). Active investing requires in-depth analysis and leads to more frequent trading, both of which lead to higher fees or costs for investors. Frequent selling can also trigger numerous tax obligations.
A passive investing strategy strives to mimic a well-defined index of stocks such as the S&P 500®—a portfolio of large American firms.
Passive investments require no in-depth analysis, incur fewer trading costs and have lower management fees. They also tend to trigger fewer taxable events.
A common analogy for differentiating these two strategies is to say that active investing is all about expending resources—time, money, analysis—on finding the few needles in the haystack that may outperform the market average. In contrast, passive investing is like saying: I don’t want to spend all that time and energy and money on finding the needles in the haystack (and likely getting some of them wrong anyway). Instead, I’ll just buy the entire haystack.
Hedge fund investing is an extreme version of active investing. Many people view hedge funds as glamourous and desirable investment choices. But the reality is that many hundreds of hedge funds have quietly gone bankrupt, closed, or merged, and many others have yielded disappointing returns for investors.
My point is that while active investing strategies seem glamorous and profitable, you’re better off avoiding them.
Lots of money managers want our money and will go to great lengths to convince us that they’re geniuses. They insist they’re the only ones who can deliver mind-blowing returns. They show us fancy presentations and secret-looking white papers arguing that their trading rules work. Sometimes they make us sign non-disclosure agreements that make us believe they really have something of value.
What does it mean when a mutual fund company shows us a track record of market outperformance over five years? Does it mean the investment can be expected to outperform consistently in future?
No! But our human brains make us want to believe this is unusual and “compelling” evidence. We forget that luck alone predicts that some funds will do better over five years while others do worse. Most fund companies manage hundreds of mutual funds. At any given time they will advertise that subset of their funds that has performed well, while quietly ignoring (or closing) those that performed poorly.
Much research has shown that the average investor is better off sticking with a passive strategy. It takes less time and effort, comes at lower cost, and allows us to focus on other priorities.
The remainder of this discussion assumes you are committed to a passive approach, investing in well-diversified, low-fee index funds.
A Different Perspective on Stock Returns from an Active Asset Manager. This link is not provided to encourage you to become an active investor. It's simply here to introduce you to more information. I have personally known the author for over ten years and interviewed him for an MBA portfolio management class offered at the Johns Hopkins Carey Business School.