Does active management win passive management? What experts know but don't want you to hear

The Straits Times posted an article last Sunday

Just last Sunday, the Straits Times published an article on the "7 habits of successful investors". In it, it lists down many characteristics, but the last one has caught my attention. It says that "go for active management".

I am part angry and part disappointed. Angry because such an article could get published passing through editorial checks; disappointed because everyday, people fall prey to the authority bias, tending to trust the experts who might have a hidden motive. I say this because the report was published by Allianz Global Investors, a fund management company.

Today, I will like to try to shed some light on this topic that most people have been deluded on. More specifically, I will show you:

What is active and passive management
What are the 7 habits of successful investors
Why active management will never win passive management

What is active and passive management

Active and passive management are two opposite and mutually exclusive styles of investing. When a fund or portfolio is actively managed, there is always a human element involved. It can be a fund manager, a group of analysts, or researchers putting inputs to an algorithm to buy and sell stocks.

By doing active management, the fund manager or investor tries to pick stocks, in the hope that they can beat the market benchmark. In Singapore, the relevant benchmark would be the Straits Times Index.

On the other hand, we have passive management. Passive management does not want to beat the index, it instead wants to be the index. You can be a passive investor by simplying buying into the Straits Times Index, and you would then get the benchmark's returns.

What are the 7 habits of successful investors

In the article by Straits Times (link: here), the author lists out these 7 habits:

Know yourself and challenge your intentions
Your investment decisions should be governed by "purchasing power preservation" rather than "security"
The fundamental law of capital investment: go for risk premiums
Invest, don't speculate
Make a binding commitment
Don't put off till tomorrow what you can do today
Go for active management

I agree with 6 of the points listed, but the last point 7 is one that is not true. I shall briefly comment on some points but elaborate more on the last one.

Know yourself and challenge your intentions

It is important to recognise what humans are poor at. We are often blinded by greed and fear, and overreact to news more often than not. I have written on personal biases previously.

However, I would also want to add that it is important to know your own risk profile, and stick to an investment portfolio that mirrors your risk profile. This way, you will be able to sleep soundly at night, instead of panicking when the market drops, or getting all euphoric when it rises.

The fundamental law of capital investment: go for risk premium

It is well known that more risk gives more return. However, most people do not know that there are two kinds of risk: systematic risk, and unsystematic risk. Systematic risk is risk that affects every single financial instrument. An example would be a global epidermic or global financial crisis. Such a risk cannot be diversified away.

On the other hand, we have unsystematic risk. Unsystematic risk pertains only to a specific country, industry, sector, or company. An example would be an earthquake in one country, or a slowdown in the manufacturing sector. These risks can be eliminated through diversification into other countries, other industries, or other companies.

Image link: http://www.acting-man.com/?p=45798

When we talk about the risk-return tradeoff, we are only rewarded by systematic risk. There is no return from holding additional risk. As a result, it is best for us to simple buy and hold the broadest and most diversified fund possible.

Further reading:
30 stocks is Not all you need for diversification

Make a binding commitment

You would probably have heard the time in the market is more important than timing the market. It is absolutely true. There are many examples of how missing just the best 10 days of any investing year would have reduced returns by 50%. Just take a look at this chart on the S&P500 by Business Insider (link: here)

And, there is no way of knowing in advance when will the best days be. So, we can only stay invested and be there when opportunity strikes.

In order to stay invested, we have to make a commitment, and invest regularly. Doing so enables us to increase our investment capital on a regular basis. Such dollar cost averaging also reduces systematic risk.

Further readings:
How missing out on 25 days in the stock market over 45 years costs you dearly
How a few poorly-timed trades can torpedo two decades of healthy returns
Forget dollar cost averaging. This is value averaging

Go for active management

Here, the author says that active management is better, due to expert guidance. I do not agree on this, and I will explain more.

Let's us try a simple analogy. Imagine there are 2 containers which either 10 or 20 balls in each container. Your task is to pick only one container and get the most number of balls. On average, what is the expected number of balls you would have?

If you answered 15, then you would correct. The average of 10 and 20 is exactly 15. In other words, you could also have opened a container containing 15 balls for sure.

What if you incur a penalty of 1 ball everytime you need to open 1 of the 2 containers but incur no penalty for opening the container of 15 balls?

In this case, it is no longer beneficial to choose the 2 containers because the average drops to 14 balls. You would be better off just taking the container of 15 balls.

The stock market works in the same manner

In the stock market, this is precisely how it works. Experts tell you that they can pick the correct containers, but you have to pay a fee to them. But, if you were to simply ignore them and buy the index (which is the container containing 15 balls for sure), you would have been better off.

Put in another way, before fees, the number of actively managed funds that beat the market would be exactly equal to the number of actively managed funds that fail to beat the market. That's because, on average, the returns from all actively managed funds must equal the index.

After fees, actively managed funds severely underperform and fail to beat the market. However, those so-called experts will still be rich because you are giving your money to them. Of course, you can say that you can pick the best manager, but the chances of doing so is less than 50%.

Running through this simple thought experiment, you would already understand that active management can never trump passive management.

What experts don't want you to hear

The reason why experts are telling you to go for active management is precisely because they can earn money from you in the form of fees. Some experts are good and have your interests at heart, and I salute them. But, not all experts are as good.

Don't ask a barber if you need a haircut, and don't ask so-called experts if active management is better. Whenever you hear a tip or some experts talking, you have to always question the intention of the source.

I always hear about seminars and courses saying they can teach you how to invest, but my question is always, why would they give up their trade secret? If I knew of a way to invest, I probably wouldn't share it. If everyone knew of it, then the method wouldn't work anymore.

The truth is, they want your money. Ignore all the hype and emotional appeals of how you can retire early and drive a nice car, it is better to stay down-to-earth and avoid such seminars which serve to only take money away from you and erode your investing capital.