Back in 2008, Warren Buffett made a $1 million against a hedge fund manager named Ted Seides, then-head of Protégé Partners LLC. Buffett believed that the average person was better off investing in an index fund and taking advantage of the longer-term benefits of passive investing than putting their money into hedge funds that are actively managed by professionals but therefore carry high management and performance fees. Buffett bet that the S&P 500 would have a better 10-year performance than a group of Protégé’s hand-picked hedge funds. In 2017, Seides conceded defeat!
The bet publicized the two fundamental investment philosophies of the world today: passive and active investing.
1. Active investment strategies are exactly that. Money managers or retail investors actively buy and sell stocks based on the expected performance of those stocks. They try to outperform their underlying benchmarks.
2. Passive investing, however, is measured by those benchmarks. Nowadays, investors can purchase index funds or exchange-traded funds (ETFs) that replicate the performance of an index like the S&P 500. Rather than hand-picking stocks or bonds, a fund manager of an index tracking fund would automatically buy all of the assets that the index tracks.
The pros of passive investing
Anyone who invests passively in an index fund or ETF should be buying and holding for the long term. Effectively, the goal is to maximize the return from the performance of the entire stock market.
Other primary benefits of passive investment include low costs associated with index funds and diversification. The broad allocation of stocks in an index fund or index-tracking ETF enables investors to benefit from the absolute performance of that index.
Passive investments can produce better after-tax results. With an active strategy, investors might be compelled to buy and sell within a 12-month horizon. The U.S. tax code for example, requires that investors pay any capital gains generated within 12 months as ordinary income. However, any investment held longer than 12 months that is sold will operate on long-term capital gains taxes, which can be significantly lower than taxes for ordinary income levels.
The cons of passive investing
You’re not going to beat the market as a passive investor because you’re effectively buying the total performance of the market itself. In fact, after fees, you’ll trail the benchmark by a small amount.
Passive investing might be a little boring on the surface. If you like to trade stocks and conduct deep research, you will not find the same entertainment here.
You’re not going to be able to react to any significant downturn in the market right away. Your money is tied directly to the whims of the broader market and the macroeconomic events that might cause a sell-off.
Sven Franssen