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.
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%.
First, let’s find what makes Active Investing so appealing to some investors.
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.
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.
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:
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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