Investing's Active-Passive Tug of War

Aug. 29, 2013 -- In investing, as in most endeavors, there's the ideal world and the real world. Ideal-world investing is for theories, while real-world investing is for real people.

Perhaps nowhere is this contrast more evident than in the classic debate over which type of asset management is better: active or passive. Active management relies on fundamental and technical analysis to determine what and when to buy and sell – or whether to be invested at all. Passive management involves capturing returns (both negative and positive) from slices of the market, usually by buying shares in index funds, which own the same stocks as those that make up the major indexes, such as the S&P 500.

The perennial debate over which of type of investing is better is as intense as the bickering between Democrats and Republicans. Advisors in the two financial camps tout market studies supporting their views while individual investors look on haplessly, bewildered by the opposing arguments.

To support their case, passive management people (indexers) point to studies indicating superior long-term aggregate returns. Many of these studies seem to be scientific and make sense mathematically. But, in many cases, they may be moot because they concern investment returns, not investor returns. The two are different.

For set periods, these studies cite investment returns — what given holdings would pay if you bought in at the beginning of the period studied. Investor returns are what real people actually earn during the periods that they actually own these same investments. Often, investor returns are far lower than investment returns because of what investment analysts call sub-optimal (i.e., human) behavior.

Nevertheless, passive management advocates recommend, just hang in there with index funds when they plummet and you'll do fine in the long run. This is great in theory, but in practice, this approach doesn't account for the human element. Especially for retired investors that are depending on their portfolio. Too many just can't stand the hemorrhaging, because they know that a 50 percent loss could mean having to go back to work. After losing too much of their life's savings when markets plummet, they typically sell low — after suffering a lot of damage. For those in or close to retirement, the pain from a tanking market — and tanking indexes — is especially excruciating. Many of them may not live long enough to see their investments come back.

When the entire market is tanking, one thing these investors can do is to get out early in the slide, take a time-out and wait to get back in the game. Many times, before the entire market suffers a major downturn, some individual stocks begin to sell off. If you have a portfolio of 20-30 stocks, you might consider setting a stop-loss on each of them at a set amount — say, 10 percent. By the time the entire market begins to crash, you may find that you've already sold a number of the holdings using your stop-loss limit.

Passive management advocates sometimes inaccurately call this practice market timing (the risky practice of investing based on predictions of the market's direction), but it's actually a form of risk management. Market timing is when investors buy or sell in anticipation of a market change. By contrast, you use a stop-loss not to time the market, but in the event that stocks you own actually begin to drop. It's not speculation. Rather, it acts as a form of loss insurance.