Using active or passive investing to reach financial freedom?

Many aspiring investors struggle to get started. In different magazines and online they read about ‘hot’ stocks that could become the next Microsoft or Google. After ‘careful’ consideration they take a leap of faith by putting money in a stock with such a ‘promising’ future! What could go wrong?

These investors are nothing more than speculators hoping to make a quick buck. Investing becomes gambling. Like with gambling in the casinos, the odds are not in your favor. By turning investing into speculating you should not expect more than the thrill of gambling with an occasional lucky strike.

But what then, is the best and surest investment approach to reach financial freedom? Active? Passive? A combination maybe?

Active versus passive investing approach

With investing there are mainly two fronts. Investors that prefer an active investment style and those that prefer a passive investment style. Both can be very suitable for different investors. Active investing means selecting individual stocks on the basis of analyzing annual reports and other company information to determine the value of a company.

After this so-called due diligence, an active investor decides whether to invest in this individual company by purchasing a number of shares on the stock market. Investing in individual stocks does not come without a substantial level of risk. Stocks of individual companies can rise or fall significantly over time or can even turn out to be worthless in case of a bankruptcy. Putting your eggs in one, or just a few baskets, can turn out to be very risky.

A passive investor, for example, buys shares of a fund that holds a bucket of dozens of individual companies. For example a bucket of stocks that represent the S&P 500 or the Dow Jones. By investing in the S&P 500 an investor has exposure to 500 well-established and profitable companies.

This way a passive investor need not analyze every individual company in his portfolio. He just follows the index in good times and bad. However, a passive investor should not expect extraordinary results. Only results in line with the index or market.

But what should you do? Investors like Warren Buffett and Carl Icahn did not become rich by investing passively. Their knowledge of stocks and businesses in general, gave them an enormous competitive advantage in investing. But then again, we are talking about two legends in investment management and business.

These men each have a unique skill set that enabled them to achieve such extraordinary results. Warren Buffett, through his company Berkshire Hathaway, has given investors annual returns of about 20.8% since 1965. Those returns are unheard of over such a long period of time. Buffett has turned many early investors into multi-millionaires. Looking back, who wouldn’t have wanted to invest in Berkshire Hathaway in 1965?

Should I look for the next Warren Buffett? Short answer: No.

But how likely is it to find an investment manager who can provide 20%+ returns consistently over multiple decades? Or if we lower the bar, an investment manager who consistently beats returns of the S&P 500 which historically averaged about 10% (before inflation)?

A 2016 study by S&P Dow Jones answers this question clearly. It is very, very unlikely. About 90% of the investment managers underperformed their corresponding indices of 1, 5 and 10-year periods. If an ‘expert’ investment manager cannot beat their benchmark over these relatively short time periods, it is extremely unlikely that you can pick an investment manager that can beat the market over multiple decades.

If you want to invest, it is best not to make use of investment managers that cannot beat the market consistently over a long period and charge hefty fees along the way.

And if the ‘experts’ which are 110% committed to beating the market fail to do so, don’t even think you can do it yourself by investing on the side in ‘hot’ stocks that were promoted to you online or in magazines. You may have your lucky streaks, but over time your best stock picks are balanced by your worst stock picks. More often than not, your returns will fall below market returns.

Are index-funds the way to go for the average investor? Short answer: Yes.

For the average investor, index-funds are a miracle. It is cheap in terms of recurring expenses, it provides diversification and it provides returns equal to the market or benchmark. Most importantly, it limits emotion. With index-funds you can reach financial freedom, but it will take time and consistency.

Warren Buffett’s mentor, Benjamin Graham, named the stock market Mr. Market. Mr. Market has so-called human behavioral manic-depressive characteristics. Mr. Market can be euphoric, moody, optimistic, depressive, irrational or a combination on any given day. Mr. Market’s mood often has an impact on investors.

Especially emotional investors are very much affected by Mr. Market’s mood. Mr. Market can praise an individual stock on one day and completely have the opposite opinion on the next. Although investors in index-funds are not immune to Mr. Market’s behavior, it is much easier to rationalize the ebb and flow of a well-diversified portfolio of hundreds of companies than it is of a portfolio with a few handfuls.

Remember, returns equal to the market are better than 90% of ‘expert’ investment managers. And that without spending countless hours reading dozens of annual reports, listening to quarterly conference calls and the stress of making the wrong investment decisions.

Especially exchange-traded-funds (ETFs) provide investors just starting out with an easy way to build a well-diversified successful investment portfolio. There are thousands of ETFs to choose from. Those that track well-established companies, real-estate, emerging markets, small growth companies, corporate bonds et cetera. All of this at a fraction of the expenses that ‘expert’ investment managers charge.

A practical example how passive investing helps you reach financial freedom

I will give you a practical example how investing through an index-fund will assist you in reaching financial freedom.

Let’s say you are 20 years old and have saved $10,000. You invest all of it in a low-cost S&P 500 index fund. The S&P 500 has historically averaged 7% after inflation. For the next 35 years you invest an additional $600 every month and reinvest any dividends. At the time you are 55, your portfolio will be worth around $1,1 million.

If you are able to side hustle and create another $500 of monthly income and invest that as well, your portfolio will be worth around $2 million.

If you add another 5 years and thus apply this method for 40 years, your portfolio will be worth around $2,9 million.

Time is your friend here due to the magic of compounding. By extending the period with 5 years your portfolio value increases with about 50%. That’s just incredible! Saving and investing $1,100 a month may not be doable for everyone, but if you work really hard, cut the useless spending and save to invest, this is possible!

But what if I do not want to choose between an actively or passively managed portfolio?

No problem! You do not have to choose as long as you know what you are doing. It is perfectly fine to allocate a larger part of your portfolio to index-funds with the remainder allocated to individual stocks.

I use the same approach for my personal portfolio. I like to look into companies’ annual reports and come up with their value by considering future prospects, current moat, etc.

But I am rational enough to understand that I am not Warren Buffett and that returns equal to the market for me are satisfactory and sufficient to give me financial freedom over the long term.

Key takeaways

  • Passive investing through index funds beats 90% of ‘expert’ investment managers
  • Avoid hefty fees charged by investment managers by investing in low-cost index funds
  • Do not expect to get rich overnight. Investing takes time.
  • Active investing can have a (small) place in your portfolio in addition to well-diversified low-cost index funds

Which side are you on? Active, passive or a combination? Any thoughts or tips on how to reach financial freedom?

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