Chapter 07 – Active or passive investing


How do you know if you have succeeded in investment?

As we say elsewhere, investing is not a race: the investor does not have to beat the other investors to have succeeded. Success is defined in terms of whether the investor meets their personal goals.

For some investors, the goal is simply to preserve the investment purchasing power of their current wealth. This may lead the investor to enter growth markets such as shares or property. The alternative, to leave the wealth in ‘low-risk’ alternatives such as cash, can run the risk of reducing investment purchasing power over time.

For example: suppose a client currently has enough money to buy a home in West Beach in Adelaide. In December 2015, the median price there was $641,250. Rather than buying the home, the client then places that money into a conservative cash investment earning 2% per year. In three years’ time, the cash investment has grown to be worth $680,000. This would be fine, except that the long-term growth rate of residential property is higher than the cash rate. If we assume that property has risen by just 5% per year over the same period (around half of the actual long-term growth rate), then the median home price in West Beach will have become $740,000. The client can no longer afford that property. In terms of their ability to live in West Beach, this client has actually lost wealth. Their cash can purchase less – they have lost purchasing power. 

People can define purchasing power in different ways. Economists point to the rate of inflation (typically the CPI) as the basis for purchasing power. A person maintains his or her purchasing power if their wealth grows at the rate of inflation.

Investors typically use a different definition. They define investment purchasing power in terms of the value of growth assets that the investor can purchase. If the number of assets that can be purchased stays the same, purchasing power is retained. This might be described as ‘maintaining investment purchasing power.’

When investors compare themselves to this maintenance of investment purchasing power, they are using what is known as a ‘benchmark.’ A benchmark is a point of comparison that tells an investor whether their specific investments have succeeded in terms of improving their investment purchasing power. If the investor has outperformed the benchmark, they will now be able tp purchase more investment assets than they could at the start of the investment period. 

When it comes to the share market, the common benchmark is an index, such as the ASX200. If the investor’s portfolio earns a better return than that indicated by the index, then the investor has ‘beaten’ the benchmark.

One of the reasons that the index is a useful benchmark is that it is possible for a share market investment to achieve the index return. This involves a ‘passive’ investment approach known as indexing, which is discussed here

As the term implies, passive investment requires little activity on the part of the investor. The investor simply acquires a portfolio that is expected to perform in concert with the index. These days, this is easily done via a managed fund, exchange traded fund or a simple portfolio constructed by the investor himself or herself.

The alternative to passive investment is known as ‘active investment.’ In active investment, as the name implies, the investor spends more time deciding which company’s shares should be included in a portfolio. The investor is seeking to achieve a return greater than the market average. Remember, the market average is reflected in the index return that could be achieved by investing passively.

Active investment involves time and effort. This time and effort only makes sense if the investment outperforms what could be achieved by a passive investment. In this way, the index return becomes the benchmark for the active investment: the active investment has performed well if it beats the index; it has performed poorly if it underperforms the index.

Choices for advisers recommending direct share investment

As detailed elsewhere, it makes sense for financial advisers recommending share investments to then recommend that the client make these investments directly. Making the investments indirectly (for example, using a managed fund) simply adds costs to the client in the form of fees unnecessarily paid to the fund manager. Advisers recommending direct investment have two options:

  1. Direct investment using a passive investment approach;
  2. Direct investment using an active investment approach.

This training module addresses both of these approaches. 

The Dover Group