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Active Investing: Leave it Out of Your Financial Planning Process

By Ron Ross | February 09, 2016

It is not uncommon for investors to ask us about the alluring possibilities of active investing. They wonder if they should try to beat the market by picking "the best" stocks or by following certain money managers.  Here's why our wealth advisors would advise not to follow this tumultuous investment style.

Ron Ross is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt CountyWe certainly understand why they might be curious about this wealth management strategy – after all, Wall Street and the financial media promote it at every turn.

Our response can be summed up by a quote from economic guru and philanthropist Rex Sinquefeld, who, while describing active managers, said that “If these guys were race horses, they’d be glue.”

Here are the top reasons not to pursue active investment strategies – and why responsible wealth advisors don’t offer active investment guidance.

Why is Active Investing an Ineffective Wealth Management Strategy?

In a nutshell, active management is a bad idea for many reasons, namely:

  • Hidden costs

  • Exceptional returns are exaggerated

  • Ignored risks

  • Lower returns connected to higher risks

In contrast, there’s only one reason why active management might be a good idea: The hope of beating the market. Unfortunately for the vast majority of investors who follow this approach, beating the market simply isn’t feasible over the long run as a vast amount of empirical and historical evidence indicates.

The pursuit of excess returns leads to diminished results at an average rate of more than 3% per year. Adding insult to injury, these lower returns are accompanied by an increase in exposure to risk, a lose-lose situation.

Burying Mistakes and Rewriting History: Survivor Bias

Research services like Morningstar evaluate and compare mutual funds’ historical performance. However, there’s a little fact that throws a wrench into that whole accuracy thing: In order to measure historical performance, the fund has to exist at both the beginning and end of the period being evaluated. Not exactly rocket science, right?

As it turns out, mutual funds’ mortality rate is greater than zero.  Many are put out of their misery, usually due to poor performance, at a rate of 7% per year, or about one every other business day. Significantly, once an underperforming fund is banished, it’s never heard from again – and that includes in the data used to evaluate and advertise. Whenever these failed funds get dropped from the stats, it provides the financial industry with an opportunity to create a revisionist history and leaves investors with incomplete, inaccurate information.

Ron Ross is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt County

This practice is akin to shooting holes in the side of a building then drawing bulls-eyes around the holes after the fact. In other words, mutual fund families simply advertise the performance of their top performers, and conveniently don’t mention the other 50 failed funds. This dubious practice is known as survivor bias, and it’s estimated to overstate the performance of actively managed funds by as much as 3% per year

Attempts to Beat the Market Hurt Your Wealth Strategies

Attempting to beat the market involves higher costs, simply because it requires more effort than does replicating market rates of return. And in order for market-beating attempts to be worthwhile, the return must be at a rate that’s greater than these extra management costs.

About 70% of investments are actively managed. It’s impossible for all funds to beat the market. Since active managers are competing amongst themselves, they can’t all be above-average, but their gross average returns can’t all be that far below the market, either. Therefore, the difference in net returns between active and passive management can largely be laid at the feet of cost differences.

Ron Ross is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt CountyBeware the Hidden Costs to Your Comprehensive Financial Plan 

Essentially, you’re paying about 4% per year to attempt to beat the market – and that’s a conservative, educated guess. While many investors realize there are costs associated with active management, most don’t have more than a vague idea of the true nature of these costs - largely because they are not widely broadcast.

While costs and fees may be included in annual reports, they’re not easy to identify. Not surprisingly, active managers like it that way.

 

Posted in Financial Planning, Diversification, Costs, and Fees, Investment Guidance

   
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