People always say to invest your money, but what does that mean? When it comes to the stock market, you can make a portfolio of stocks with the hope of increasing its value. To create a balanced portfolio, there must be diversification: investment in a variety of stocks in order to get “as much exposure to the market,” reducing risk, says Cynthia Plouche, a former portfolio manager. The goal of diversification is to mirror all aspects of the market (defined as all stocks that are publicly traded), as the market has historically increased over time. “Despite this principle, only 34% of people say they make sure their investments are diversified” (Leonhardt, “Only a Third of Americans Say They Avoid This Investment Mistake”, 2019). This leaves the remainder of people risking losses and financial insecurity. One of the best ways to address this is by investing in a fund, a predetermined portfolio that is managed by professionals, either actively or passively.
Active investing involves buying and selling to follow a specific investment strategy, and therefore, the funds are not necessarily as diversified. However, professionals managing these funds try to outperform the average returns of a particular set of stocks called an index. The index serves as a benchmark for what the fund’s returns should be. Since actively managed funds strive to outperform the market, they frequently carry high fees to cover the cost of skilled portfolio managers.
Passive investing, on the other hand, limits the amount of buying and selling in order to produce returns similar to an index fund in the long term. Passively managed funds closely mirror index funds, which means less trading, lower fees and lower capital gains taxes. Therefore, “by reason of its substantially lower expense ratio, a passive index fund, compared with more costly actively managed funds, could enhance an investor’s savings by more than 20%” (Bogle, “The Arithmetic of ‘All-In’ Investment Expenses”, 2018). So the next time you hear someone telling you to buy a specific stock, pause. Remember the advantages of having a diversified portfolio to reduce risk. Consider the differences between active and passive investing. And don’t forget to follow the advice of Justin Sheperd, a Chartered Financial Analyst, and “understand the potential taxes and fees.”