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I’ve never really liked the labels, “passive” vs “active” when it comes to investing.
They’re meant to describe funds that simply track the market versus those that try to beat the market.
But the view they give of the investment process is way too simplistic. And the choice they suggest – that of a lazy investor willing to accept second-best, as opposed to a dynamic one willing to risk it all for glory – is misleading, particularly for those less familiar with the City jargon.
The fact is, everyone has to make “active” investment choices.
Let me explain, with the aid of a typical beginner investor’s journey.
Here’s what you need to do before you even start thinking about investing
Making the decision to start taking investing seriously is anything but passive. As an individual investor, the first thing you need to do – before you even consider sprinting into the maw of the stockmarket – is to work out where all your money is right now.
Because unless you really are just starting out, you probably have bits of pensions hanging around, the odd insurance policy, savings accounts – our finances can become remarkably untidy over time.
So you first need to get a handle on where everything already is. And then you need to sit down and work out where you want it to be.
For most people, this isn’t complicated. First, clear your debt, except your mortgage or student loans (which are a whole other topic). There’s no point on saving and investing at one end if you’re paying out double-digit interest on a loan at the other end.
Second, think about what you are saving for. Again, for most people, this is pretty simple. You need a “rainy day” cash fund of about three to six months’ salary, so get that stashed away first.
Beyond that, most people’s savings goals boil down to two things: a house and retirement. (If you’ve got enough money to deal with those two, you can then start to worry about what I like to think of as “luxury” financial goals, such as the kids’ education, deposits for kids’ homes, funding a career break or gap year, and the like.)
If you’re saving for a deposit on a house, that’s a short-term goal, so realistically, most, if not all, of that money has to be saved in cash. (To be clear, buying a house is not the right decision for everyone or at every point in time. This is just a generalised illustration of what most people want.)
So once you’ve paid off your debt, set aside money for emergencies and satisfied your housing needs, what’s left is retirement. You’re building up a pot of money for the distant (or not-so-distant) future.
In the UK, there are two main savings vehicles that are used for these long-term savings: Isas, and pensions. I won’t go into the details of each here (there’s plenty of other material on the website if you want the full rundown), but they are both tax-efficient in different ways, so your investments should be held in one or other or both.
The wonderful world of asset allocation
I don’t know about you, but to me that’s a lot of activity simply to get to the point where we can even start talking about investing. And there are a lot more decisions to make now.
You know you want to save for the long run. But what should you invest in? This is where asset allocation comes in. And this is where you have to get seriously active.
I like to keep asset allocation simple. Simplicity is good, because it stops you from getting overwhelmed and making too many decisions, which is one of the main obstacles to developing good investment habits.
From that point of view, there are five basic things that you can invest in. Equities (shares), bonds (IOUs), property (directly or through funds), gold, and cash.
They all behave a bit differently to one another. That’s the point of asset allocation. If the world is going through a period that’s bad for shares, then chances are it’s not as bad for bonds. If it’s bad for gold, it’s probably good for everything else.
But how much should you put in each one? That really depends on two things. One is your time horizon. If you have lots of time to go until you will need this money (ie, you are in your 30s, say), then you can afford to own more “risky” assets. So you might have the vast majority of your portfolio in equities, with small allocations to the other four asset classes.
As you get closer to retiring, and – probably more importantly – closer to the size of pot that you think will be sufficient to fund your retirement, you want to reduce your risk. So you’d probably increase your allocation to bonds and cash, and reduce it to equities (again it’s more complicated than this, but we’re talking broadly here).
A quick point to emphasise, while we’re here – if you only remember one thing about risk management, make it this: once you have “enough”, the upside you get from having “more than enough” is far, far lower than the downside you experience from dropping from “enough” to “insufficiency”.
What’s the other thing to consider when doing your asset allocation? That’s your attitude towards risk. As far as I’m concerned this should be dictated almost purely by your time horizon. If you’ve got 40 years to go until you retire, stick your money in equities, and ignore it. Grin and bear the fact that you may well live through another 2008.
But if you know that you can’t handle that, then you might want to take less risk (and in the meantime try to develop a better understanding of risk so that you can develop healthier investment habits).
It’s not so much active vs passive, as expensive vs cheap
So there you go. You’ve tidied up your finances and set your financial goals. You’ve decided on your asset allocation. That’s a lot of activity.
Now you’re close to the finishing line. You want to put some of your money in equities. Which equities? The UK stockmarket? The US stockmarket? The Japanese stockmarket? Emerging markets?
Go for a geographical split, and resist “home bias” (the desire to stick most of your money in your local stockmarket). The UK accounts for a small proportion of global market capitalisation so it certainly shouldn’t be taking up 50% of your investment portfolio.
So that’s a whole lot more decisions you have to make. Once you’ve decided which equities, you can finally figure out how you’re going to buy them. And now, finally, this is where the “active” vs “passive” terminology comes up.
Say you want to invest in the FTSE All-Share. You can buy an “active” fund: the manager tries to beat the market (hence the “active” name). They will charge you for their efforts. The problem is that they most of them fail to beat the market consistently. (There are ways to improve your odds of tracking down decent active managers, so don’t dismiss them out of hand, but you need to do your homework.)
Or you can buy a “passive” tracker fund or exchange-traded fund (ETF). These simply track the market (hence the “passive” name). You will get the same return as the underlying stockmarket – you won’t have any chance of beating it. But because the fund is effectively automated, you will pay a lot less for this than for an active fund. And the less you pay out, the more of the return you get to keep, and the quicker your investments can compound.
So there we go. I think we can agree that “active” vs “passive” is a misnomer. We’re all active investors. A better and more truthful terminology for funds, I think (with a few admirable exceptions), would be “expensive” vs “cheap”.