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.