Passive vs. Active Investing: Keeping Your Costs Low
Warren Buffett probably doesn’t need an introduction but, as CEO of Berkshire Hathaway investment group, he’s one of the richest people to ever exist on our planet. As of writing, Buffett is worth $90 billion and has also given $34.5 billion to charities since 2006. But Buffett winning money isn’t something you hear about every day.
More than a decade ago, Buffett wagered against hedge fund manager Thomas Seides that passive management of investments would offer better returns than actively managed investments. Buffett recommended investing in the S&P 500 Index. This prediction then saw an annualized rate of return of 7.1% from 2007 through 2017 while the basket of hedge funds only saw 2.2% during that same time. The way that Buffett and Seides structured their bet proved interesting with the end result allowing Buffett to donate his winnings of $2.2 million to Girls Inc charity in Omaha, Nebraska. Count this story as a win for Passive Management!
So why is Warren Buffett betting against hedge fund managers in the first place? He’s vocal against hedge fund managers for two reasons: First, hedge fund managers charge hefty fees and, second, they frequently trade positions. This adds more transaction costs as they try to beat their benchmarks in attempts to prove that they can beat the market.
To follow Buffett’s lead, here are the two major areas to consider when keeping your investment costs low:
1. Avoid excessive management fees.
2. Limit transaction costs.
Passive management helps you tackle both of these cost-cutting areas with slashed management fees and also fewer transaction costs. Passive management is the “boring” investment philosophy, but it has a lot of believers.
It’s principles: Ride the waves of the market, keep your costs low, and buy and hold.
These aren’t exciting to tell your pals at a cocktail party, but you can give yourself a lot of peace of mind knowing you’re not getting caught up in investment crazes (cough cough … Bitcoin).
Again, remember you can control these aspects when it comes to the prices of your investments.
1. Avoid excessive management fees
According to John Bogle, the founder of Vanguard, investors are better off investing in low-cost index funds instead of money managers who try to beat benchmarks. As Bogle said,
“If we go back to 1970, we find that there were approximately 400 funds in business and basically 330 or 40 have gone out of business. It turns out, in that period, there were two mutual funds who beat the market by more than two percent per year. Two! That’s half of one percent of all the funds that started in the business. Those are your odds.”
What to remember: Instead of paying 1-2% to someone who claims they can beat the market, save the money you’d pay for their investment analysts and have that money go toward your investment account. If you pay someone for performance, you’ll be amazed at all the random sheets of statistics and charts they can generate to justify their investment philosophies. By investing in passive management, you can also save a lot of paper!
2. Limit transaction costs
Think of the well-known S&P 500 Index. This index is made up of 505 stocks from the 500 largest U.S. companies that are publicly traded on American stock exchanges. The bigger the companies (like Apple), the bigger their influence on the index while the smaller the companies, less weight they have on the index.
Instead of buying 505 different stocks as well as paying the transaction costs applied for each individual trade, you could purchase one index fund or exchange-traded fund (ETF) to follow the entire index. This helps you as you keep your costs low and also immediately improve your diversification. Another benefit is that, when companies become less profitable (cough cough… Enron), they are removed from the index while another company is added.
We enjoy helping our clients navigate these areas of the investment world to make it simpler. You worked hard for your money, so why not have your it work hard for you?
Many trends come and go, and it’s refreshing to hear Barry Ritholtz, an American author, newspaper columnist, blogger, equities analyst, and Chief Investment Officer of Ritholtz Wealth Management say:
“It seems that every time there’s any major trends, whether it’s towards global investing or passive investing or day trading, it’ll last for a couple of years and then something new and shiny comes along and enough people are interested in it that a substantial portion of the previous trend participants will chase that. However, I will say that the evolution towards low-cost, towards indexing, and towards being aware of how your own behavior impacts your investing, is something that’s going to be here for the foreseeable future.”
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For more resources on the benefits of Passive Management:
- Freakonomics Podcast episode: The Stupidest Thing You Can Do With Your Money
- Read Burton Malkiel’s book, A Random Walk Down Wall Street: A Time Tested Strategy to Successful Investing
- Eugene Fama’s research on the Efficient Market Hypothesis
To read some more of our thoughts on investments: