For buy and hold investors, some like to actively pick and choose individual assets to buy, while others prefer to invest in the entire market. But which is a better investment strategy? Similar to a cronut, the answer is simple, but may not be obvious.
Which Investment Style is Better: Passive or Active?
The Cronut is a pastry that combines together a croissant and a doughnut. It was invented by New York City pastry chef Dominique Ansel and is trademarked. You should try one if you ever visit NYC. 🙂 They cost $5 each. But you can also find cronut knockoffs in Mexico that are much cheaper than the real thing, so you don’t peso much. 😄
Anyway, why is this relevant to investing? Because much like a cronut, the better investing strategy between passive and active, is not one or the other, but both. 😀 By combining individually selected assets, and index funds into one single pot, we can create the ultimate investment portfolio. This takes advantage of low-cost index funds, while adding alpha (excess returns) in certain segments of our portfolio. 😉
So how can we implement this? First, we actively pick and choose specific investments in the areas that we have extensive knowledgeable about. Then use the passive investing method to buy index funds for all other asset classes that we have insufficient knowledge about.
For example, I selected individual farms to buy in 2012/2013 because I knew how to look at soil quality, flood risk, earnings potential, etc. Therefore, I knew how to find undervalued land. Historically speaking higher quality farms appreciate faster than lower quality ones so I made sure to only buy farms above a certain quality. Farmland funds however, invest in all quality land. As a result I have outperformed every farmland or agricultural based ETF I could find on the stock market. So within the context of this asset class, passive investing would not have done me any good.
On the other hand, when I decided to get into the United Kingdom stock market last year, I decided to buy a low-cost stock market ETF. European stocks are beyond my comfort zone. I wasn’t about to perform due diligence on all 250 stocks of the FTSE 250 index. So that’s why I invested in a broad market UK index fund instead which contains those 250 individual stocks. 🙂
This is why self knowledge is very important for investors. We should try to use our strengths and specific knowledge to produce better than average outcomes in certain types of industries or asset classes. Then we can aim for average market returns in all other areas that we do not understand. Overall, this should give us a higher investment return than either a completely passive approach (which will give us average market returns), or a completely active approach (which will most likely result in under-performing the market.)
But in order for this combined investment approach to succeed we have to know the limits of our knowledge and capabilities.
Defining your Circle of Competence
Warren Buffett said that the reason for his investment success is he stays within his “circle of competence.” He only invests in something he understands well. He says the most important thing in terms of your circle of competence is not how large the area of it is, but how well you understand where the perimeter is.
I know someone who has been working in the real estate industry for over 10 years. He underwrites private loans, and investments in mortgages. He has scoured the country for the best deals and knows where to find the highest returns on investment for rental properties. Plus his wife is a certified real estate agent who can buy and sell homes. He does extensive research on real estate companies and his returns have helped him become a millionaire before the age of 35. So I would say that real estate investing is very much within his circle of competence. This means it wouldn’t make sense for him to invest in a broad market real estate index ETF, eg: XRE.TO, because he can probably do better picking individual investments in this category. Famous investors and entrepreneurs are successful because they leverage their knowledge and stay within their circles of competence. As billionaire Mark Cuban once said, “diversification is for idiots.” Lol.
Even though I have some index funds, I am still primarily an active investor of dividend stocks. This is because I’ve seen multiple comparisons online with graphs showing dividend growth stocks outperforming the index. Value investing also outperforms the index over time. But I have not seen a single study where it shows index investing beating dividend aristocrats over a 10+ year period of time. Since the couch potato method of index investing has inferior historic returns compared to dividend investing, my strategy is to buy mostly dividend stocks. 🙂
But to say that one style of investing is always superior to the other would be shortsighted. We all have to decide what’s best for us. So just do whatever butters your biscuit. 😀
Food for Thought
Investing is a lot like food. Passive investing is like following a popular diet or meal plan program. You don’t have to think. You just do what the diet tells you. This may be the appropriate choice for some people.
But others may choose to discover unique diets that work better for themselves. This is similar to active investing. It requires research. We would have to study recipes, macro nutrition, biology, physiology, digestion, and learn how our own bodies react to certain foods. We would end up with a diet that is unlike any other. One that will best fit our body’s needs and match our lifestyles.
Following mainstream diets and customizing a personalized diet are both valid ways to stay healthy. Similarly, passive investing and active investing are both valid financial strategies as long as we have a plan that works for us.
Index investing is excellent for the majority of retail investors starting out. Most people don’t have time to research the markets and analyze their investment opportunities. But over time as investors become more experienced, they can specialize in certain parts of the market. As they learn how to determine the value of individual assets, they can be more selective about what they invest in, and rely less on index investing as time goes on.
Random Useless Fact: