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Investment professionals have engaged in a longstanding debate over which style of investing yields the highest returns. Some argue that passive investing, supported by studies analyzing historical investment performance, provides evidence that it is a superior approach. However, others criticize such research for its failure to accurately classify active and passive strategies. So, which style of investing should we employ, and what are the different approaches available to us? Let’s delve into these questions and more.
Contrary to popular belief, investing is not simply a mathematical equation with inputs and outputs. It is more akin to playing a musical instrument than solving algebraic problems. Mathematics offers a concrete model where a problem has a single solution, but investing encompasses various styles, each with its own unique approach. Just like there are different ways to play the drums—such as rock drumming and jazz drumming—investors must choose an investment approach that aligns with their goals.
Whether you aim to build your own portfolio or purchase a fund, understanding the different styles of investing is crucial. At the core of each approach lies a subscription to either the active or passive school of thought, which present conflicting views on whether investors should try to beat the market.
Passive investors believe that consistently earning higher returns or outperforming the overall stock market is impossible. They argue that researching and hand-picking individual holdings is costly and, instead, advocate for diversification and employing a buy-and-hold strategy that mirrors the market’s performance. Passive investors believe this approach will generate satisfying returns in the long term.
Active investors, on the other hand, believe that stock prices often deviate from their intrinsic value, creating opportunities to earn additional returns. They operate on the premise that investors are irrational and susceptible to cognitive and emotional biases that lead them to transact shares at illogical prices. Active investors actively seek opportunities to buy or sell when stock prices differ from their perceived intrinsic value.
These different viewpoints impact how an investor manages their portfolio. For example, consider an active and a passive investor who both decide to purchase Security A. The passive investor will proceed to buy the security immediately, while the active investor may analyze the stock’s price and determine whether it is currently overpriced. If they conclude that it is, they may wait for the price to fall before making their purchase. If the active investor’s analysis is accurate, they will be able to buy the same stock at a lower cost, potentially earning a higher return compared to the passive investor. However, there is always a risk that the stock price may never fall as expected.
Both active and passive approaches have their pros and cons. Passive investing is generally cheaper to implement due to lower research and transaction costs, providing it with a natural advantage. However, passive portfolios are highly correlated with market performance, making passive investors vulnerable to market downturns. Active strategies, on the other hand, employ techniques to hedge against market downturns and may outperform during recessions. However, active strategies come with higher fees and may not consistently deliver better results.
The active versus passive debate is intense, and the performance of each approach varies depending on the economic environment. Passive investors typically fare well in periods of low market volatility, while active investors tend to outperform during high volatility when prices fluctuate more dramatically. Economic theory suggests that markets experience cycles of high and low volatility, meaning there will be periods when active strategies outperform passive ones, and vice versa.
Beyond this fundamental dichotomy, investors adopt different ideologies regarding how they select their holdings. There are three high-level methods: fundamental, technical, and quantitative analysis.
Fundamental analysis involves researching a company’s business, examining its assets, management information, and other data points to estimate its value. Fundamentalists seek companies with strong leadership teams, consistent profitability, and solid business structures. They analyze the value of the company and look for opportunities where they believe the stock is trading at a different price than its actual worth. Fundamental analysis is common among mutual funds and popular investment vehicles due to its economic rationale. However, critics argue that there is no consistent approach for fundamentalists to consistently beat the market due to the numerous subjective inputs and judgment calls involved.
Technical analysis, on the other hand, focuses on patterns in stock prices to predict when values will increase or decrease. Technical investors pay little attention to a company’s fundamental information and instead analyze historic prices, searching for patterns that can guide their investment decisions. Critics of technical analysis question its lack of economic rationale and its reliance on historic information. However, proponents argue that all relevant information is reflected in stock prices, making it the only data point worth analyzing.
Quantitative analysis, a style that has gained popularity with the rise of data science, utilizes mathematical models to objectively determine which securities should be bought or sold. Quantitative investors establish relationships between financial factors, such as volume and earnings, and use statistical models to make decisions. One notable quantitative model is the Black-Scholes model, commonly used to price stock options. Advocates of quantitative analysis believe it offers a scientific approach to investing, completely ignoring qualitative factors such as product quality. However, concerns about potential data mining and the inability of models to adapt to dynamic changes in the finance field exist.
These are just three high-level styles of analysis, and many investors combine approaches to formulate their investment strategies. Additionally, there are numerous granular approaches to stock selection, such as growth investing, value investing, focusing on small or large-cap companies, and employing top-down or bottom-up approaches based on economic or company-specific views.
By understanding these underlying philosophies and approaches, investors can better navigate the available investment services and tailor their approach to their needs. Just as musicians choose their preferred style—be it active or passive, rock or jazz—investors can establish their own preferred style of investing. Remember, the investment landscape offers a diverse range of options, and by comprehending these different styles, you can make informed decisions to meet your financial goals.
