When thinking about retirement savings, one key question that jumps at you is, “What can I invest in?”. If you faced that dilemma, you are not alone. This is a typical question every investor and advisor asks. And the answer was even more controversial.
In 2016, Warren Buffett famously wrote in a letter to the shareholders of Berkshire Hathaway that, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
This bold statement by the notorious investor and the “Oracle of Omaha” fueled the long-lasting debate of active investment versus passive investment.
Why Retirement Savings?
The majority of us would love to set back one day and relax knowing that we don’t have to work again. And that we can enjoy spending our days just enjoying life. In the pursuit of that goal, the smart of us, start their retirement saving early while they have a decent income and the ability to work hard in order to be comfortable in their days when they can’t work/earn as much.
But basic research on the topic will show you that things are not as straightforward. Setting aside part of your income is just half the job, you still need to invest that money into a retirement savings plan (usually a fund or group of funds) in order to generate returns i.e help your money grow with time.
This is when things get interesting. As it turns out, not all investments are created equal. And while saving for retirement, one must pay close attention to the details and the fine print. In this article, we will try to shed some light on 3 different types of investment schools and highlight their pros and cons.
If you go ahead and ask any active investor, what is his/her goal?
The answer usually is that they want to consistently “beat” the market over a long period of time. Beating the market simply means they want to make a higher return than the average market return.
Many active investors tend to keenly watch the market and study financial statements/industry reports in order to “cherry pick” stocks in their portfolios. All of this is time-consuming and requires highly specialized skill sets. Many investors who do not have the time to do all this simply choose to engage with a professional fund manager to actively manage their investments on their behalf. In return for their services, these actively managed funds typically charge management fees ranging somewhere between 1% and 3%.
Pros And Cons Of Active Investing
First, let’s find what makes Active Investing so appealing to some investors.
Active managers can “cherry pick” their portfolios which might have the potential to outperform the market. “A diamond in the rough” as they say.
Active managers can use various techniques like short sales or buying put options to exit specific stocks/sectors when they sense the tides of the market shifting. Theoretically, since active managers always have their finger on the pulse of the stock market, they should be able to make timely decisions to exit the market. However, in reality, are they consistent in predicting these shifts? is a topic of discussion for some other time. On the other hand, passive investors keep their investments for the long haul.
- Tax management:
Although active managers will usually have the tendency to overtrade which in turn will trigger capital gains tax, they do have the option of tailoring tax management strategies. Tax harvesting is an example of one such strategy in which the active investor will sell stocks they are losing money on, to offset the taxes on the big winners.
So, if active investing is that great, why isn’t everyone on that side of the boat? Well, here are some things to consider before making that call.
Actively managed funds have a high expense ratio. Explicit cost including front-end load, back-end load, management fees are just one part of the equation. There are many other hidden/implicit costs that the investor bears as well such as transaction and brokerage costs, spillage costs, delay costs etc. All the costs create a significant “drag” on the returns over a longer period of time.
With higher risk comes high reward. That part of the statement is true, but what we fail to realize sometimes is that risks might not always pay off either. One wrong decision could potentially wipe out all your hard-earned gains on your investment portfolio.
Investors like Warren Buffet and Charlie Munger know that most individuals simply cannot outperform the market on a consistent basis when investing actively. In fact, even if they somehow manage to do that on a gross of fee basis, the drag on returns created by the fees related to active investment, in the long run, will itself be enough to pull your returns below the average market returns.
Passive index funds are simply the only smart choice available to 90% of average retails investors. There is simply no other way.Warren Buffet
The goal of a passive investment is to match the market, not beat it. Index Funds and Exchange Traded Funds (ETFs) are suitable investment vehicles for retirement savings. They replicate the performance of indices like the Dow Jones Industrial Average Index or the S&P500 index. Since there is no active management involved, so the costs of these funds are also minimal.
In 2018, the average expense ratio of an actively managed equity fund was 0.76%, whereas it averaged around 0.08% for a passively managed equity fund. Although this difference might not look significant, but it adds up over time due to the compounding effect as can be seen in the graph below.
This is why, on a (Net of Fee)basis, active mutual fund managers’ returns trailed passive investment funds consistently over a recent 10-year period. In 2019, 71% of large-cap US. Actively managed equity funds underperformed the S&P500, as reported by S&P Dow Jones Indices’ SPIVA.
This simple yet approach to retirement savings has its own merits:
Very low fees that keep the returns in the investor’s pocket, not the fund manager’s.
- Tax efficiency:
Index funds buy and hold strategy does not trigger a large annual capital gains tax.
Investors always know the composition of their investment portfolio.
Best of both worlds
Instead of relying on just one approach, take advantage of both approaches in unison. How do you do this?
Dynamic passive portfolios are useful in this regard. They follow an investment strategy that frequently adjusts the mix of asset classes to suit market conditions. The stock and bond components of a portfolio might be adjusted based on the stage of the economic cycle the industry is in. Sector rotations are also carried out which ensures that the retirement savings portfolio is well positioned to benefit from sectors that are expected to perform well in the future.
Using this approach, you will be adapting your retirement savings portfolio periodically while using passive investment funds.
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