What is the best strategy for investing? What is buy-and-hold? What is the Rule of 72? What is the Rule of 100? What is day-trading? Should I try and time the market? Do I have too much at risk?
These are just a few of the dozens of questions we hear regularly from new clients when we first meet. The financial world and all its jargon can seem overwhelming, especially to those who like to research the topic online. The internet can keep you entertained – or confused – for hours on end, with many theories, strategies and conflicting opinions on the best way to invest. How do you boil it all down and make sense of it for your own situation?
I had a conversation like this recently when I met with long-time clients and friends, I’ll call Dave and Janet. These folks both retired just last year and came in for their annual retirement plan review, bringing their youngest son, Ben, with them. Ben is doing his residency at Martha Vineyards Hospital, specializing in cardiology. After many grueling years of school and internships, he’s finally making his own living. His parents decided now is a good time to get some basic investment advice to set him on his own path to retirement.
Now, there is no question that Ben’s very smart. I’m sure the amount of knowledge he has in his pinky finger about the left and right ventricles would make my head swim. But when it comes to his finances, he has a lot of questions, and understandably so. And because the topic of investing is so large and often complex, we decided to break it down into a number of smaller topics to get started.
Since I don’t have enough space here to write the 300-page book it might take to go over all-things finance, I’d like to spend our time this week going over just two types of investing strategies at a high level – active and passive investing.
You see, active investors research and follow companies closely and buy and sell stocks based on their view of past and future trends. Most folks don’t have the time or expertise to handle this type of investing on their own, so this is a function typically delegated to qualified investment managers. Generally speaking, the goal of active managers is to outperform certain standard benchmarks. For example, if you’re an active US equity investor, your goal may be to achieve better cumulative returns than the S&P 500 or Russell 3000 . . . cumulative returns over time not average.
Passive investors, on the other hand, buy a basket of stocks, regardless of how the market is faring. This approach requires a long-term mindset that disregards the market’s daily fluctuations. Your goal would be to match the performance of certain market indexes rather than trying to outperform them. This tactic often involves purchasing exchange-traded funds that provide exposure to an index like the S&P 500. Because you’re buying and holding securities of companies included in an index, neither you – nor a fund manager – are actively trading in and out of the account.
Historically, index investing has tended to outperform actively managed funds over the long-term. According to the SPIVA scorecard produced by S&P Dow Jones Indices, 83% of actively managed large-cap funds underperformed the S&P 500 Index over the past 10 years and 85% lagged the benchmark in 2021₁. In addition, actively managed funds tend to charge higher fees than low-cost ETFs.
Passive ETFs are more tax efficient. Because they track various indexes, they don’t frequently buy and sell individual stocks and therefore you won’t see significant capital gains taxes reported each year while you hold the funds. With active investing, you’re more likely to see capital gains reported each year due to the regular buying and selling that goes on throughout the year.
The downside to passive investment, however, is that they provide no real active risk management — you own the best and the worst companies of the index you’re tracking. You get the good, the bad and the ugly all in one package, so to speak, with no one intervening to manage the portfolio in times of market stress and volatility.
It’s these kinds of extreme markets where active fund managers get a chance to showcase their skills. This is where they can use various strategic and tactical management techniques to move in and out of certain investments, or even cash, to help mitigate large losses in turbulent markets. Rather than sitting on the sidelines and watching what happens next, active investing is just that – actively trading securities in an attempt to smooth out volatility and prevent market losses. And to help offset the potentially higher tax bill that comes with active management, some advisors recommend putting those investments in a Roth account, which allows tax-free withdrawals in retirement, or a tax-deferred account like an IRA or a 401(k).
So basically, active managers may outperform when the market is volatile, or the economy is weakening. On the other hand, when specific investments held within the market are moving in unison, passive strategies may be the better way to go.
So, which one makes sense for you?
Naturally it will depend on your risk tolerance, where you are in your financial lifecycle, among other factors. A combination of passive and active might be a good solution because it can help smooth out returns over time. Whichever you choose, be sure it’s part of a complete retirement system – one that includes downside risk mitigation to help ensure your foundation is protected, no matter how the markets perform.
And as always – be vigilant and stay alert, because you deserve more!
Have a great week.
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield, MA. Insurance offered through its affiliate, CutterInsure, Inc.