Passive or Active Portfolio Management

Investors have a decision to make when it comes to managing their portfolios. In the investment portion of your financial plan you can choose to actively or passively manage your portfolio. There are many compelling arguments for and against both approaches. However, before we dive into the details of which strategy is better, we must first discuss the theory of efficient markets.

The debate concerning the efficient market theory revolves around the concept that the price of a financial instrument (a stock, bond or other assets) already reflects all past information concerning its valuation. This means that the price of the financial instrument accurately reflects the true market value of the underlying asset.

On the other side of the debate there are investors that believe that the market is inefficient and that all information concerning the valuation of an asset is not known by everyone. These investors believe that financial instruments can be over or undervalued at any given time, thus they can take advantage of these price discrepancies to make a larger profit.

Active Portfolio Management

More often than not, active portfolio managers believe that markets are inefficient and that if they try hard enough they will be able to “beat the market” by identifying mispriced securities or by timing buy and sell transactions. These investors believe that they have an edge on other financial market participants.

An active portfolio manager spends a lot of their time researching publicly traded companies and staying up to date on global economics. Depending on their investing and trading style, they will read through company’s financial statements, create their own mathematical models and use technical analysis hoping to find an undervalued asset to buy or an overvalued asset to sell.

Active portfolio managers can beat the market, however consistently beating the market is rare. In addition, many active investors do not quantify their time spent researching different securities and therefore do not consider it an additional cost of their investment activity. If this cost was considered when determining portfolio performance, the statistics would show that the additional gains above the market as a whole would be insignificant.

Passive Portfolio Management

In contrast to active portfolio managers, investors that believe that markets are efficient, usually take a passive approach to portfolio management. These investors take the position that financial instruments are, for the most part, priced fairly at any given time. With this in mind, they refuse to spend their time looking to uncover the next high profit investment opportunity.

Passive investors will usually lean towards index funds that track specific segments of the market. In addition, these market participants will not attempt to time the market to squeeze a little more return out of their positions.

Despite their “hands off” methodology, passive investors will take the time to find the right balance of asset classes for their portfolio. They will conduct research in the attempt to create a portfolio that fits their risk tolerance, income and capital appreciation needs. In doing so they will create a portfolio with a variety of asset classes (stocks, bonds, commodities, futures, etc.) and market capitalization (i.e. small cap, mid cap, large cap stocks).

Combining Active and Passive Management

Similar too many other aspects of financial planning, when it comes to choosing an investing methodology there is no absolute right or wrong. The choice to actively manage your assets is completely up to you, neither solution is better or worse than the other. The only decision that really matters is determining which investing methodology fits your lifestyle and expectations.

With that said, you don’t have to choose one investment style over the other. If you participate in your employer's 401(k) you have the opportunity to take a passive approach in that investment account. This can be an easy decision due to the constraints that these accounts usually place on its participants.

If most of your invested assets are tied up in retirement accounts, you can choose to actively manage your personal investments. In doing so you can attempt to improve your overall returns. Unlike employer sponsored retirement accounts, investing in an individual account provides the flexibility to invest however you please. Having both accounts and using both methodologies can provide some great opportunities in your financial plan.

When it comes to seeking the best investment strategy, neither passively or actively managing your portfolio is more advantageous than the other. Choosing which method is right for you depends on your lifestyle and personal interests.

The Investment Decision Making Process

Investing has a major role in financial planning. This is due to our reliance on investments to increase our wealth and assist us in reaching our financial goals. Despite the importance of investing in our financial plans, many people are hesitant about investing as they are unsure about where to start. Like financial planning, investing also has a logical and systematic process for successful implementation. Using a defined process when tackling complicated tasks helps us keep our focus and improves our chances of success. The following illustration of the investment decision making process has been simplified, however it provides a great foundation for starting your quest for investing knowledge.

Budgeting, Cash-flow and Capital Needs

In the beginning of the investing cycle, you should begin by determining how much you can and need to invest. To calculate how much you can afford to invest you will need to build a budget and analyze your cash-flows. Your budget will assist in determining how much income you have left over after expenses. This amount will be how much you can afford to invest.

In addition to calculating how much you can invest, it’s wise to determine how much capital you will need in the future. I will leave the instructions on how to accomplish this for another post. However, you can still start to create a simple estimate on how much you will need to retire and make a list of your other future expenses.

Determine the Right Asset Allocation

Asset allocation is the process of deciding how much of your capital to invest into the different categories of investments, such as stocks, bonds and cash. The right asset allocation strategy for your situation is heavily dependent on the amount that you can invest and your future capital needs. Your asset allocation should also take your risk tolerance into consideration.

In the most likely scenario, if you do not have enough capital to invest based on your future needs you will have to allocate more resources to high risk/ high reward investments. On the other hand, if you have a higher savings rate you should be able to reduce your exposure to risker assets.

Selecting Financial Instruments

Once you have determined the right asset allocation strategy for your situation, you will then get the opportunity to choose individual bonds, equities, mutual funds and other financial instruments for your portfolio. The types and amounts of the assets that you buy should be based on your asset allocation strategy.

When selecting which stocks and bonds to invest in there are a few critical criteria that you should consider. First, always research and understand what you are investing in. Second, timing your transactions can make or break an portfolio; carefully plan when you buy and sell securities. Finally, pay attention to global economics and the business cycle as it could save you a lot of money and frustration.

Please keep in mind that this is a very high level illustration of the investment decision making process. Investing can become a complicated endeavor, however sticking to these fundamentals will help you simplify it to the bare essentials.

The Major Types of Investments

It can be expected that anyone new to financial planning will wonder what investment types are available to them. There are a few major types of investment classes available to everyday investors. Understanding the differences between these asset classes is fundamental to developing an customized and effective investment strategy.

Fixed Income Investments

Investments that have a fixed income schedule are considered fixed income securities. More often than not, when financial planners discuss fixed income investments they are referring to debt instruments such as bonds. However, this class of investments also includes savings accounts, treasury bills and certificates of deposit.

Fixed income investors are usually rewarded through interest payments or, in the case of treasury notes and bonds, an appreciation of the asset’s value as well. However some fixed income investments, like zero coupon bonds sell at a discount to their face value. At maturity the investor, nets the difference between what was paid and the face value of the bond.

Equity Investments

When you buy a share of common stock in an company, you have just become part owner of that business (thus you have equity in the company). Investors in common stock can profit three ways. First investors can buy the stock low and sell high, keeping the difference. Second, some stocks distribute income to shareholders through dividends. Finally, savvy investors can “short” a stock by selling high and buying back low, netting the difference.

Exchange Traded and Mutual Funds

Very popular types of investments include mutual funds and ETFs. There are thousands of different types of funds in the market. Funds are usually comprised of different assets and are based on a theme. Fund themes can include index matching like the S&P 500 or Dow 30. In addition funds also can also be sector or company size specific.

Mutual fund companies pool their investor’s cash and make asset purchases on the investor's behalf. Investors seeking hassle free investment management usually find mutual funds serve their needs. However fund investors looking for a “do-it-yourself” solution, like ETFs for their flexibility.

Investment Derivatives

Investments such as options, futures, warrants and swaps are considered derivatives. This is due to the value of the investment being derived from the value of the underlying asset. In example of this relationship, the value of an stock option depends on the value of the stock the option is based on as well as additional factors such as time and volatility.

Derivative investments range from being relatively simple to extremely complex. As with all investments, its wise to conduct good research before placing any derivative in your investment strategy or portfolio.

There are four major types of investments. They include fixed income, equity, funds and derivatives. Understanding what these investment types are will help you develop your investment strategy and build an effective portfolio.