Which is Better—Passive or Active Investing? Yes!
Earlier this year, Vanguard announced the passing of founder John Bogle, one of the best investors of our time and also one of the true innovators in the financial services industry.
Bogle founded Vanguard back in 1974, and one of the very first products they offered was revolutionary: a mutual fund that tracked the S&P 500. Before Vanguard, it was nearly impossible for an individual investor to monitor and invest in the 500 top companies that the Standard and Poor’s index tracks and weights based on performance. Bogle’s fund created a new way for investors of all sizes to tap into the wealth-building power of the markets that other firms have been emulating and refining ever since.
On today’s show, we dig a little deeper into how indexing works in 2019, the differences between passive and active investing strategies, and the key things you need to know if you’re thinking about adding an index to your portfolio.
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Key Points on Active and Passive Indexing
1. A primer on indexes
The S&P 500 is a stock market index based on 500 large companies listed on several U.S. stock exchanges. It’s also weighted to account for the sizes of the companies it’s tracking. This means that the larger the company, the more impact that company has on the performance of the index. For example, the top three stocks in the S&P 500, Microsoft, Apple, and Amazon account for around 10% of the index’s weighting.
By contrast, the Dow Jones Industrial Average is a price-weighted index of 30 stocks. So instead of calculating the price of the index based on the size of the company (like the S&P 500), the Dow Jones is calculated based on the price of the stock. The Dow is also based on just 30 stocks that its creator thinks are representative of the economy, which is why the Dow dropped GE last year. That’s also why giants like Apple and Google aren’t listed: their prices are so large they would throw off the system Dow Jones uses to compute its average.
The implications for you as an investor in the S&P 500 index are that while technically, you're getting the performance of 500 stocks, it’s a very small percentage of the biggest companies accounting for a substantial percentage of your return. Conversely, if that small percentage of companies is struggling, they might have an outsized negative impact on your portfolio, especially if your investments are not properly diversified.
There are also other less-famous indexes that you can consider, such as international indexes, emerging market indexes, small cap indexes, mid cap indexes, and fixed-income indexes.
2. Passive vs. Active Investing
One thing that made Vanguard’s S&P 500 index stand out when it was introduced was that it was passively managed. There was no management committee making buying and selling decisions; Vanguard just followed the rules that the S&P had used to create the index. Your money went into the index fund, and your return was based entirely on how the S&P 500 performed.
This was a big change from traditional active management, in which an investor would choose to buy and sell individual stocks, either working alone or with the help of an advisor.
3. Your Fiduciary Advisor: The Best of Both Worlds
When I was just starting out in finance and passive index investing was still relatively new, there were some hardline arguments between advisors and institutions who believed investing should either be all active or all passive.
Today, I think it’s safe to say there’s a consensus that balancing active and passive investments is a reasonable strategy. And that’s how we operate at Keen Wealth. We do use passive investment strategies in many of our client’s portfolios, but we believe it is important to actively manage the weightings of those very same holdings. We also balance those with active management in individual securities as well. We try to focus our clients’ investments in companies that we believe are “shareholder friendly,” meaning that they pay dividends, buyback shares rather than issuing more, reduce debt, and aren’t in the middle of costly mergers or acquisitions.
We believe that a mix of active and passive investing can increase the potential of our clients’ portfolios in the long run. This is a belief that Vanguard also agrees with, according to a study they published in 2016 that references how financial advisors may potentially add about three percentage points of net investment return for their clients’, when following a disciplined framework.
Yes, indexing may be an important part of your financial planning strategy. And yes, both the S&P 500 and the Dow Jones may provide significant opportunities for investors. But the services that Vanguard studied – rebalancing, diversifying, and helping clients keep their cool during volatility – are all vital to wealth-building as well.
If you’d like to discuss how indexing is affecting your portfolio, make an appointment to have one of my fiduciary advisors walk you through all your options.
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Bill Keen is a CHARTERED RETIREMENT PLANNING COUNSELOR℠ and independent financial advisor with more than 25 years of industry experience. As the founder and CEO of Keen Wealth Advisors, a registered investment advisory firm, he specializes in providing personalized retirement planning designed to help people thrive before and during their retirement years. With a passion for educating others, Bill regularly blogs about retirement planning, hosts the podcast Keen on Retirement, and has contributed to U.S. News and World Report, Reuters, Wall Street Journal’s Market Watch, Yahoo Finance, and other publications. Based in Overland Park, Kansas, Bill and his team work with clients throughout the greater Kansas City area and across the nation. To learn more, connect with him on LinkedIn or visit www.keenwealthadvisors.com.
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