Active Or Passive? : Arriving At An Answer

The debate as to whether to opt for active portfolio management or passive investing is an age old one. It has raged on for decades and will continue to do so in the future. Proponents of both approaches can claim to have logical reasons in support of their stance. This is what makes the debate that much more intense. And today I will talk about the questions one must ask themselves and answer honestly before choosing either approach. 

Am I Willing And Able To Meet The Core Demands Of The Approach? 

Each of these approaches comes with a set of core demands that investors must meet. Active portfolio management demands time, knowledge and effort from the investor. All three of these would be required on an ongoing basis. This means that the investor needs to constantly study, track and manage various components of their portfolios. This needs to be done at regular intervals. Finally the investor must make peace with the fact that their portfolios would go through periods of underperformance. 

Passive investing on the other hand demands humility and maturity from the investor. The investor must be humble enough to accept that it is virtually impossible to beat the average market return over the long term. They must be mature enough to realise that having enough money for their goals is more important than generating a stellar portfolio return. Maturity would also come in handy in terms of helping the investor avoid investment FOMO (Fear Of Missing Out). 

Investors must objectively assess which of these sets of demands they are better positioned to meet. Some investors may find that they can meet some, but not all of the demands of either approach. In such a case it would be better for them to begin with passive investing. They may switch to active management later if they feel confident enough. This is because active management is the more aggressive one among the two approaches. Shifting from a defensive approach (passive investing) to an aggressive one (active management) is simpler than doing things the other way around. 

Am I Sensitive To Paying Taxes On My Investments? 

Active portfolio management implies a requirement for frequent portfolio churn. The aim of active management as a strategy is to earn a higher return than the market average. Investors may therefore need to keep adding outperforming investments and remove underperforming ones frequently. This would naturally lead to a bigger tax bill for the investor. Active management should therefore be chosen by those who are insensitive to frequently paying taxes on investments. 

Passive investing is better suited to those who keep a close eye on the size of their tax bill. Passive investing as a philosophy focuses more on asset allocation and aligning an investor’s portfolio to their goals. Once this is done, only a minimal degree of effort and intervention is required to manage the portfolio. This naturally means that passive investing is likely to result in a much lighter tax bill for the investor. 

Have I Demonstrated My Ability To Stick To My Desired Approach During Tough Times? 

This is a much more pertinent question for those who wish to employ active management as their desired strategy. Most investors who adhere to active management as a strategy typically run concentrated portfolios. This is even more true for younger, more inexperienced investors. Concentration in portfolios can take the form of an outsized allocation to a single asset. It may also manifest in the form of a number of products with similar characteristics being held under a single asset class. 

Concentrated portfolios typically end up being harder to manage and live with. An investment strategy is only as good as the investor's ability to stick to it consistently. Those who prefer active management must therefore have gone through at least an entire market cycle without stopping or selling off their investments. I firmly believe that this is the only way they can be sure of their ability to successfully adhere to active investment strategies. 

Of course, those who prefer passive investing must also demonstrate the same degree of discipline. But it is important to note that asset allocation and diversification are central to passive investing. This means portfolio allocations are much more likely to remain balanced across assets and asset classes. Passive portfolios typically consist of a few, thoughtfully chosen products. This improves the chances of investors being able to stick to the strategy. Passive investing is therefore better suited to those who lack experience and/or prefer simplicity in their portfolios. 

Is Everyone In My Family As Financially Savvy As I Am? 

A portfolio is built for an individual. But it is meant to serve their entire family. The level of financial awareness of the individual's immediate family therefore becomes an important consideration. The term immediate family in this context refers to the individual's parents, siblings, spouse and children. In the case of most families, one member is typically a lot more financially aware and savvy than the others. Now think of a situation where a less financially savvy member needs to step in to manage the portfolio. 

They would definitely have a hard time understanding and handling complex portfolios that require constant management. Therefore passive investing would be a better choice of strategy for such families. If professional help is sought, the professional would also find it easy to understand a simple passive portfolio. In the rare cases where most or all family members are as financially savvy as the others, active management may be preferred. 

The Parting Word 

Choosing either of these approaches makes no sense unless our goals and desired asset allocation have been defined. It is also important to note that both these approaches are symbiotic. In other words, each of these approaches essentially requires the other to remain relevant. I will discuss the reasons behind this in a future post. This implies that neither active management nor passive investing can be viewed as the superior outright. We therefore need to discern which of these strategies would be a better natural fit for our individual personalities, ground realities and behavioural preferences. Tying our choice of approach to these aspects improves our chances of sticking to it consistently. This gives us a reasonable chance of success regardless of the approach we ultimately choose. 

I personally believe in the passive approach and advocate the same to my clients. My conviction in the passive approach is highly unlikely to reduce in the future. But I respect the fact that there are those who believe that active management is right for them. This is completely fine. It is important for us to respect proponents of the opposite approach to ours. Criticism of the opposite approach based on hard facts and sound logic is always welcome. Blindly ridiculing proponents of the opposite approach is not. That way everyone would be a winner regardless of the approach they choose to follow.