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By: Sam Instone

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November 10th, 2016

The best way to invest

Investment

[Estimated time to read: 3.5 minutes]

Which is the best way to invest? 

Confusion abounds because the industry says one thing, but the evidence says another.

The truth is, there are only two choices. 

One works and one doesn’t…

So, don’t be baffled by the range of investment funds and managers, or the number of financial advisers or even commodities in the world.

Best way to invest

Best way to invest

Just choose between passive and active

Like I said, one works and one doesn’t…

The industry’s favourite way to invest

Those who work in the financial industry vend products and solutions; they make money through sales. 

These people sell you investments that are actively managed, because these products and solutions make them the most money in commissions and fees.

What is active management?

If you invest in a product or solution that is actively managed, your money will be looked after by a fund manager who will:

  • attempt to identify mispricing in securities;
  • rely on forecasting to select undervalued securities or,
  • attempt to time the market; and
  • generate high expenses, trading costs and risks.

Active managers buy when they think they can outperform the market, and sell when they think their holdings are overvalued.

As an investor choosing an actively managed approach, you pay for everything – from the fund manager’s wages to their high dealing costs. 

You pay out of the profit they make for you – unless of course they don’t make you any profit. 

In which case you still pay, but the money is taken out of your invested capital. 

Active management has very low odds of success. 

Over the long-term, 97.8% of actively managed global equity funds have failed to beat their index, after fees and charges.

Active Management

(Click image to view our investment code)

That means if you choose the industry’s favourite way to invest you are almost certain to lose money.

Active management – a summary

Active management is guessing, predicting and speculating. 

As Benjamin Graham, the economist, investor and teacher of Warren Buffet said:

“The individual investor should act consistently as an investor and not as a speculator. 

What does the evidence show us?

The opposite of active is passive. 

Passive investing has many names; some people call it tracking, others call it indexing, but my favourite name for it is evidence-based investing, because that is exactly what it is. 

It’s investing based on evidence – not guesswork or speculation or baseless predictions.

What is passive management?

Passive management is a style of investment management associated with exchange-traded funds (ETFs), trackers and index funds, where a fund's portfolio mirrors a market index, like the FTSE 100 or S&P 500 for example.

Passive investors:

  • hold a basket of securities representing an index;
  • track and attempt to match an index;
  • remove the risk of trying to pick stocks, guess the market and outperform it; and
  • spread risk, diversify, cut costs and improve returns.

Passive investing

The science behind the common sense

In financial economics there is a theory called the efficient-market hypothesis. 

It maintains that market prices reflect all available information and expectations. 

So a stock’s current price is the best approximation of a company’s intrinsic value.  

Any attempts to identify and exploit stocks that are mispriced will most likely fail, because stock price movements are random, and largely driven by unforeseen and unforeseeable events.

Of course mispricing can occur, but there’s no predictable pattern for this. 

So this hypothesis suggests that no active fund manager will ever be able to consistently beat the market over long periods of time – unless by complete chance of course. 

Therefore, stock picking, market timing and active investing cannot ever be reliably depended upon to add enough value to outperform a passive investment management strategy.

That’s the science behind what is actually just common sense.

Passive management – a summary

Passive investing means:

  • not having to waste time stock picking and market timing;
  • ignoring the short-term randomness of the markets (we call this noise);
  • having a structured, diversified portfolio, balanced to manage risk; and
  • positioning a portfolio for long-term growth in the capital markets.

US$7 trillion is invested in passive funds in America and Europe. 

Passive Management

(Click image to view our investment code)

So, which is the best way to invest money?

The approach you choose has to be right for you. 

Passive isn’t perfect for everyone. 

But the general consensus of professional opinion is that passive is the best approach for most investors.

Want to know more?

  1. If you want to know more about the science, philosophy, evidence and process behind our organisation’s investment code, have a look at our slideshare.
  2. If you want us to benchmark your portfolio’s performance and see if your money could be better invested, we’ll give you our professional second opinion for free.
  3. If you want to get started with passive investing, learn more about our Index Account.

What do you think is the best way to invest? Let's meet in the comments. 

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About Sam Instone

Sam Instone, CEO at AES International, is passionate about positive change and ensuring expat investors get the best results.

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