Crackerjack Greenback Prudent Advice for a Prosperous Future

November 14, 2008

What is Active Investing?

Filed under: Investing,Retirement Planning,The Basics — Paul Williams @ Crackerjack Greenback @ 4:00 am

New York Stock Exchange by wenzday01 on Flickr       If you’re new to investing, you’ll soon hear about the two main styles of investing – Active Investing and Index Fund Investing. Before we can really discuss either of them at length, we need to have a definition for each approach. I’m going to set out here my definition for Active Investing, and next Friday I’ll discuss my definition of Index Fund Investing and what it means.

Characteristics of Active Investing

       Rather than start out by giving a simplified definition of Active Investing, I’m going to start out by describing some of the characteristics of Active Investing and the behaviors of Active Investors.

1.  Active Investors believe they can pick specific stocks that are going to “outperform”. They also often believe that there are other people, usually Active Mutual Fund Managers, who can pick the “right” stocks as well. The idea is that with enough research and the right insights or methods, you’ll be able to find values that other people have missed and make a fortune in the process.

2.  Active Investors think they can figure out when to get in and out of the market or a specific type of investment. They believe it is possible to tell when they should sell all their stocks and put everything in cash. Or they think commodities (or any other specific asset class) are overvalued and it’s time to start buying foreign stocks (or some other specific asset class). This is often called “Tactical Asset Allocation”, but it’s essentially Market Timing any way you look at it. Active Investors often apply the same line of thinking to individual stocks or bonds.

3.  Active Investors often think a mix of U.S. Large Company stocks provides adequate diversification. The truth is there are many other types of assets in the investment world, and you need a mix of several to be truly diversified.

4.  Active Investors often invest without thinking about risk. If an investment is a good value, you should just put your money in it, right? Wrong! You first have to consider the risk of the investment and your own risk tolerance before investing. You also have to consider the risk of not meeting your goals.

5.  Active Investors often invest without first reading the academic research about free markets and investing. Academia offers us a much less biased view of investing than the materials we see in the financial media and the advertisements of financial services companies. If you really want to understand investing, you need to learn a bit about what academic research tells us.

My Definition of Active Investing

Charging Bull, Wall Street by carlossg on Flickr       Active Investing is basically any investment strategy aimed at “beating the market”. This means Active Investors are attempting to get a higher net return than a relevant benchmark or index. The net return should be adjusted for all additional commissions, loads, fees, expenses, and taxes. You should compare the results over at least 10 years, but preferably over 20 or 30 years, to get a meaningful comparison. Most Active Investors fail to take all of these factors into account when comparing their performance with an appropriate benchmark. They usually don’t even pick an appropriate benchmark!

A Better Way

       Next Friday, we’ll talk about the alternative to Active Investing – Index Fund Investing.

2 Comments »

  1. “If you really want to understand investing, you need to learn a bit about what academic research tells us.” Well said!

    So many people just read the magazines or watch CNN. Why not try and find an unbiased source of information?

    Also, thanks for the link! 🙂

    Comment by Mike @ Oblivious Investor — November 14, 2008 @ 9:32 am

  2. Exactly, Mike! Granted, not all academics are completely and totally unbiased, but you’ll find far more material that isn’t sponsored by the same person who’s trying to sell you the investment (or a magazine).

    You’re welcome for the link. You’ve got some great stuff at your website, so I’m sure I’ll continue to find articles I can link to!

    Comment by Paul Williams @ Crackerjack Greenback — November 14, 2008 @ 9:41 am

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