Active Investing VS Passive Investing, Lump Sum VS Dollar Cost Averaging: Which Investment Strategy Suits You Best?
25 January 2018
Before you start investing, there are a few important questions that you need to ask yourself. Frequently, many newbie investors don’t even consider them until very much later.
Active Investing Or Passive Investing?
If you are fairly new to investing, you may not be able to differentiate between these investment methods. However, if you wish to be successful in the long run, it’s important for you to understand how they differ.
What Is Active Investing?
In the past, active investing was simply investing. People invest in stocks and other asset classes because they believe these assets would increase in value over time. Likewise, they sold assets if they believe it would decline in value. The idea was simple; to generate returns from an investment.
Today, many active funds and individual investors focus their efforts not only on making money, but also on outperforming the benchmark index in which their performance is often measured against.
For example, the Straits Times Index (STI) is seen as a proxy for the Singapore stock market performance. If the STI generates a return of 4% for the year, an active fund manager or individual investor should be targeting to generate a return higher than 4%.
The logic here is simple: if investors were not confident of beating the benchmark index, then investors would be better off just investing in an Exchange Traded Fund (ETF) that tracks the index itself.
What Is Passive Investing?
Investors embarking on a passive investing strategy simply aim to replicate the market performance rather than trying to generate returns that are higher than what the market has delivered.
For example, such an investor may invest in the STI through one of the two STI ETFs in Singapore, the SPDR STI ETF and Nikko AM STI ETF, both of which are listed on the Singapore Exchange (SGX).
By investing in either ETF, an investor can expect to receive a return that is similar to the performance of the STI, after accounting for management fee of close to 0.3%.
Investors who prefer this investment method could also invest in ETFs that track other listed country indexes, or even asset classes such as individual stocks and bonds.
Misconceptions About Active & Passive Investing
When it comes to active and passive investing, there are a few common misconceptions that we would like to address.
#1 My Investments Are In A Unit Trust/ Mutual Fund That I Don’t Manage. Hence, I Am A Passive Investor.
Many investors, even experienced ones, make the mistake of thinking that they are taking a passive investment approach just because they are investing in a unit trust or mutual fund. This is not true.
When you invest through a unit trust or mutual fund, you are actually engaging a fund manager. Most (though not all) fund managers are active managers who buy and sell investments in an attempt to generate a higher return (than the market) for their clients. Hence, investors who invest in these unit trusts or mutual funds are actually taking an active investment approach.
#2 Passive Investing Is “Safer” And Always Delivers A Better Return
Some investors think that passive investing is “safer”. This is untrue.
Passive investing, when executed correctly, delivers the benchmark market return. However, this does not equate to an investor taking less or more risk.
During an economic downturn, passive investors are equally exposed to losses as active investors are. In fact, active investors may even be quicker to react by shifting their investments to safe haven assets, such as cash and gold.
Passive investing also tends to work better in efficient markets. Efficient markets can be understood as markets where assets are fairly priced, and where having further insights and better analysis will not allow investors to make higher returns than what other investors in the market are getting. In general, more developed financial markets such as Singapore and the U.S. tend to be recognised as more efficient markets compared to markets that are still developoing.
In markets that are less efficient, having deeper insights and better analysis can allow investors to make higher returns than what other investors are getting. These are the markets where active investing may work better.
#3 I Am Not Required To Do Much As A Passive Investor
Attracted by the notion of not having to monitor their investments or worrying about economic cycles, many new investors subscribe to passive investing.
While this tends to be true, passive investors still need to set an asset allocation strategy. You will rarely find ETFs that are invested into different asset classes.
You also have to rebalance your portfolio as you age, set a different goal as market values of your investments fluctuate.
Is Active Or Passive Investing Better?
Neither active nor passive investing can claim to be better than the other. It simply depends on your preferences as an investor.
Here are some factors that you should consider when deciding whether active or passive investing suits you best.
>> Are you willing to take on more risk in order to achieve a higher return than the market? Or are you contented with getting a return that is close to what everyone else is getting?
>> Do you have the time, knowledge and interest to actively manage your own investment portfolio?
Your responses to these questions will determine whether active or passive investing suits you better.
Lump Sum VS Dollar Cost Averaging
While active and passive investing can be seen as two different approaches towards investing, lump sum and dollar cost averaging are two different ways where people can start investing
Lump sum investing is when you decide to invest a large sum of money all at once. In contrast, dollar cost averaging is when you invest a small sum of money each month over a longer period of time.
For example, if you have $5,000 in savings that you wish to invest, you could invest all of your money at once into the stocks, bonds or ETFs of your choice. This is known as lump sum investing.
Another possibility will be to slowly invest $100 over the next 50 months into the same group of assets. By investing a fixed amount of money each month, you will buy more stocks when prices go down and fewer stocks when prices increase. This is known as dollar cost averaging.
The key difference between lump sum investing and dollar cost averaging is market timing. When you invest in a lump sum, you are looking for the best time to enter and invest into the assets that you want to buy. If you buy assets when prices are at its lowest, great. However, there is also the possibility that you may invest all your money into the financial market when prices are at its highest.
When you employ a dollar cost averaging method, you are reducing the potential effect that market timing may have on your investment. By investing a small sum of money each month, the effect of entering the market at the wrong time is significantly reduced. Instead, you will now be paying an average price for the assets that you wish to invest in.
Whether you choose to invest your money using a lump sum or dollar cost averaging method, or decide between an active or passive investing approach is entirely up to you. The important thing here is to understand what the differences are between these methods and approaches, and to choose what makes the most sense for you,
By understanding some of these basic investment concepts, you can ensure that your investment decisions are consistent with your investment objective before you even start investing.