The Difference Between Active and Passive Investing

Once a month, I meet up with some smart people in my neighborhood to drink coffee and try to stave off mental decline by talking about hard financial topics: macroeconomics, taxation, and sometimes even something useful, like investing. It’s like Facebook chat, only you can smell the other participants.

At our last meeting, the topic was active vs. passive investing. Before we could get into that debate, however, we had to define our terms. I was arguing the passive investing side, which meant I had to come up with a definition of passive investing. This proved to be a lot trickier than I thought, and more fun.

I’m not going to get into the passive vs. active debate in this column. I just want to see if I can figure out what we’re talking about before I wade into that debate in the near future.

“What is passive investing?” may seem like an arcane question that nobody but latte-fueled intellectuals should care about. On the contrary, pal: if you’re saving money for the future, deciding whether to take an active or passive approach is among the most important decisions you’ll make.

Who’s active?

Active investing, as I define it, means trying to beat the market over a particular time period using one or both of the following strategies:

Security selection. This is a fancy term for buying the right stocks (or bonds, or funds, or any other asset) and avoiding the wrong ones. It means having the foresight to buy Apple in the pre-iPod days and not to buy Netflix on the day after its IPO.

Market timing. Markets gyrate. If you can correctly predict those gyrations ahead of time, you can make a lot of money—or avoid losing it.

Passive investing means doing neither of those things. It means diversifying as much as possible by buying broad market index funds. It means owning the next Apple, but also the next Groupon. And it means not trying to time the market. That means staying in when stocks take a dive five days—or months, or years—in a row.

Passive investing also means making portfolio decisions based on personal circumstances, not on headlines or research.

Who’s passive?

With that definition in mind, let’s cook up a couple of hypothetical investors and see who’s passive and who’s active. (Aren’t these terms a little judgmental, by the way? That’s why MintLife columnist Dan Solin likes to refer to passive investing as “smart investing.”) This is my column, so I get to be the judge and jury. We’ll start out easy.

Alice owns a bunch of individual stocks and bonds and trades them regularly.

Verdict:Active.

Bob owns no individual stocks or bonds, only low-cost ETFs, but he trades them regularly in response to perceived market trends.

Verdict: Active.

Charlie buys mutual funds, holds them, and never trades. However, his mutual funds are actively managed, so the fund manager may be trading stocks within Charlie’s funds.

Verdict: Active.

Donna buys diversified index funds or ETFs, holds them, and never trades.

Verdict: Passive.

Rick Ferri, in his book The Power of Passive Investing, puts these four investors into a handy chart, which I’m going to simplify and reproduce here.

 

 

As you can see, only Donna meets Ferri’s (and my) definition of passive investing.

The hard cases

Now, let’s ask some tougher questions.

Emily owns only index funds and ETFs, but she has decided on a 50% stock/50% bond portfolio.

Verdict: Not enough information.

If Emily has chosen a 50/50 portfolio because it’s in line with her risk tolerance, she’s passive. If she believes this portfolio looks like a winner for the moment but intends to change it later when stocks look like a better bet, she’s active.

Frank owns only index funds and ETFs in a 50/50 stock/bond portfolio, but he trades once a year or more to bring his portfolio back in line with its original allocation. That is, if bonds go up and stocks go down, he sells off some bonds to buy more stocks until he’s back to 50/50. This is called rebalancing.

Verdict: Passive.

Rebalancing is about keeping your portfolio risk under control; it’s not about trying to time the market.

Gene used to have a portfolio of 75% stocks/25% bonds. Recently he received an inheritance. He checked his retirement savings calculator and found that with the new infusion of cash, he could take less stock market risk and still have an excellent chance of reaching his savings goal, so he switched his allocation to 50/50.

Verdict: Passive.

Gene is changing his portfolio based on a change in his circumstances, not anything to do with market trends.

Hailey is a buy/hold/rebalance type like Frank. A couple of years ago, however, during the financial crisis, she noticed that prices on certain bonds had plummeted. She took the opportunity to buy some highly-rated bonds at bargain prices and permanently reduced her allocation to stocks.

Verdict: Hmmm.

I’m not sure. It smells like market timing, but is it?

Get your Team Alice t-shirts here

Alice, our pure active investor, works hard at investing. She is up on the latest IPOs, valuations, interest rates, and market trends. She has a whole folder of investing apps on her phone.

Meanwhile, Frank, our passive buy/hold/rebalance guy, doesn’t know anything about any of that stuff, and he spends a few minutes a year managing his portfolio.

You can probably guess whose team I’m on, but let’s talk about you: are you an Alice or a Frank or someone else from our cast of characters? And why?

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.