Investors Obsess Over Active vs. Passive Investing: There’s a Third Option

Mitchell MauerResearchLeave a Comment

What is the best approach to building a common stock portfolio: active or passive investing? This has been an ongoing debate for several decades. However, few investors realize there is a third option which is far superior to either of the first two: systematic investing.

Systematic investing combines the best attributes of active and passive investing while eliminating the downfalls of each. So what is systematic investing and why is it the best?

A brief comparison of all three approaches quickly reveals why systematic investing is undeniably the better alternative.

What is Active Investing?

Active investing is a hands on approach to building a common stock portfolio. It requires careful analysis and selectivity of each individual stock. The goal for active investors is to beat the market through expertise — forecasting the operating performance of individual companies. Generally speaking, an active portfolio is heavily concentrated and relies on the success of each individual investment.

Benefits of Active Investing

The appeal for active investors is the ability to have complete control over their investments. Active investors have full say in what they buy, when they sell, and how much capital they allocate to each stock.

Drawbacks of Active Investing

That’s not to say that active investing doesn’t have its drawbacks. To succeed as an active investor — and consistently beat the market — it takes a lot of work. The odds are stacked against any individual stock picker trying to build long-term wealth. Investing is a zero-sum game where you compete against tough competition. Charles Ellis, author of the book The Index Revolution put it this way:

“If you know anybody in the investment management world, you know they all work terribly hard. They’re all very bright and they all have terrific equipment and lots of resources in the way of information. The only problem is, so does everybody else. Today, when you buy or sell a stock, whether you’re a professional or amateur, you are buying and selling from professionals. Half the trading is done by the 50 largest, most aggressive and probably toughest professionals.”

Individual investors — without access to highly paid teams of analysts and expensive databases — are at a strong disadvantage. On top of all that, an investor’s competition isn’t even his biggest adversary. It’s himself.

Individuals who attempt to beat the market by using their expertise, run the risk of making bad decisions. Multiple studies in the field of behavioral economics conclusively show that humans are inherently bad investors. Our survival instincts allow us to persevere as a species, but cause us to fail at investing. For example, following the herd (buying when everyone else is) and running away from danger (selling when stocks are down) are exactly opposite of what a successful investor should do.

With all the drawbacks of active investing, surely passive investing is the way to go, right?

What is Passive Investing?

If active investing is hands-on, passive investing is a hands-off approach to building a portfolio. There is no careful analysis or selectivity of individual stocks. Passive investors simply buy an index fund consisting of the broad market and stand back. More often than not, a passive investment strategy involves the process of dollar cost averaging — consistently investing the same dollar amount on a set schedule.

The goal for passive investors is to match the returns of the entire market. Any passive strategy is inherently diversified. Just one index fund is comprised of hundreds of individual companies. Therefore, passive investors do not attempt to forecast individual companies or specific industries. They rely on the long-term performance of the market’s group outcome.

Benefits of Passive Investing

Where active investing requires a tremendous amount of work against stiff competition, passive investing doesn’t involve any effort. When properly implementing a passive investment strategy, investors can’t make bad decisions. Putting the same amount of money in the same fund on a consistent basis doesn’t allow for any second guessing.

Most importantly, passive investors don’t risk underperforming the market. They forfeit the opportunity to outperform the market for the guarantee of matching its returns. Evidence shows that over multiple decades, passively investing in an index fund is a sure way to build wealth.

According to Jim O’Shaughnessy, author of the book What Works on Wall Street, passive investing is successful due to consistency:

“The reason this works so well is that the S&P 500 never varies from this strategy. It doesn’t wake up in the morning and say, ‘You know, small-cap stocks have been doing well recently. I think I will change and become a small-cap index,’ nor does it watch as Ben Bernanke gives testimony to Congress and say, ‘Yikes! Today I’m going to become the S&P cash and bond index!’ It just continues to passively implement the strategy of buying big stocks, and that is why it’s so effective.”

Drawbacks of Passive Investing

For all of its benefits, passive investing has its drawbacks. Passive investors have no control over their investments. Not only must they own what the index owns, they must allocate according to the index as well.

Likewise, passive investment strategies are highly diversified. There is no statistical advantage to owning hundreds of stocks at one time. In fact, evidence shows that owning just a few dozen stocks provides better returns with no increase in risk.

Guaranteed average returns are the most significant drawback for passive investors. While average is not bad, it’s not great either.

How can investors achieve great returns while enjoying the advantages of passive investing and simultaneously avoiding the drawbacks of active investing?

What is Systematic Investing?

Systematic investing is a passive approach to actively selecting individual stocks. It relies on a rule-based system to quantitatively build a portfolio. In an attempt to achieve better than average returns, systematic investors choose stocks based on attributes which increase returns. Typically, they utilize a stock screener to find stocks meeting the specific attributes and valuation factors of a particular strategy.

This approach works for the same reason passive investing does. It consistently implements the same strategy regardless of recent performance or short-term expectations. The difference is that a systematic approach buys individual stocks rather than index funds. Instead of owning what an index owns, systematic investors buy and sell based on the results of the applicable stock screener.

Why Systematic Investing?

Like a passive investment strategy, there is no forecasting involved. Rather, systematic investment strategies depend on the success of the entire portfolio. Additionally, with this approach investors have complete control of what they own. As with an active investment strategy, systematic investors decide what to own, when to sell, and how much money to allocate to each stock.

Having complete control over their investments, allows investors to find the “sweet spot” between too little and too much diversification. Furthermore, systematic investors can hold stocks for the ideal amount of time. Depending on price movements, investors can sell overvalued stocks and hold on to undervalued stocks.

By basing investment decisions on the results of a stock screener, investors remove the behavioral biases associated with active investing. There are no emotional decisions to make when strictly following a rule-based system. Plus, systematic investors can improve upon the results of passive investors by following a strategy with the right valuation factors.

How do individual investors create their own systematic investment strategies?

Create Your Own Systematic Investment Strategy

Building a common stock portfolio based on a systematic investment strategy is pretty straightforward. Creating your own systematic investment strategy requires four simple steps:

Pick a stock screener to follow:

The stock screener you select will determine the criteria and valuation factors a stock must meet in order qualify as an investment. This is a critical step as it sets the foundation for the strategy you are going to implement. You want to pick a screener that makes intuitive sense and has a proven track record.

Determine how many stocks your portfolio will own:

How diversified do you want to be? Although the exact number is a matter of personal preference, a systematic investment strategy should own between 10 and 30 different stocks. Under 10 will increase volatility and minimize the odds of capturing “winning” stocks. Over 30 becomes too difficult to manage and increases the probability that “losing” stocks will drown out the returns of the “winners.”

Decide how much money to invest in each stock:

Equally-weighting the stocks in a portfolio is the simplest and most effective allocation method for individual investors. This means you invest the same amount into each stock. With this approach, investors end up buying more shares in lower-valued stocks and less shares in higher-valued stocks.

Set “buy” and “sell” rules:

Deciding how often to rebalance the portfolio is the last step in creating a systematic investment strategy. The “buy” and “sell” rules should spell out exactly when to add (buy) or remove (sell) a stock.

Most Important Factor

The most important factor of any systematic investment strategy is consistency. The specifics of any strategy are not as critical as consistently implementing the strategy.

In order to profit in the stock market, investors should take control of their investments while eliminating behavioral biases. Following a systematic approach is the best way to do this.

Mitchell Mauer is the Founder of The Stock Market Blueprint is a site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.

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