Active vs. passive investing

Public conversations have become difficult. I’m not the first to realize this and by no means have a cure, but I do have a suspicion as to why. Those on the extreme of any issue are the most passionate, loudest, and most willing to make provocative, attention-grabbing statements. As a result, characterizations of issues dominate conversations and not much attention is given to where it is needed most: the reasonable middle ground.

In M1’s world, that of managing your money, a critical question many ask is, “How should I invest?” People respond with holy war-esque fervor in the form of the “Active vs. Passive” investing debate. Each side proudly states their side’s benefits and then demonizes the other. What’s become the most provocative viewpoint of all gets lost: both sides have pros and cons.

I plan to lay out both sides of the issue to conclude it’s not an either-or. Your investing can occupy the wide-open gray-zone and try to maximize the strengths of each side while minimizing the weaknesses. At M1, we like to call this “engaged investing,” and we have built our platform for exactly this type of money management.

Passive Investing

The argument for passive investing comes from one simple premise: costs matter. And the premise is correct; every dollar paid in fees reduces your total portfolio by that same dollar – and isn’t earning future returns for you either. Therefore, passive investing pundits contend the number one priority in investing should be reducing your costs.

Consider this thought experiment. If you took the universe of financial assets and tracked it over the next ten years, the collective would have one return. However, any individual, trading in and out of these assets, will have a return that differs from the whole’s. Most people would do about average, earning the overall market’s return, but there would undoubtedly be winners and losers (whether by luck or skill). Hence, the distribution of returns may look something like this:

But oftentimes, transaction costs and management fees reduce returns dollar-for-dollar — even on free platforms like M1, taxes play a role. So, an active investor would shift their return to the left to represent their after-fee returns. Now, imagine a passive investor whose goal is to be average and minimize costs. Their return will shift as well, but by a much smaller amount.

This is the rationale for passive investing and comes with the conclusion that if you try just to be average but reduce your fees, you will make above-average returns.

Passive investing adherents stop the conversation here, as if it were so simple. Even though the logic holds, there are two fundamental problems:

1. You cannot buy the universe of financial assets. There are indexes that try to cast a wide (but truthfully arbitrary) net, but they’re always taking a sliver of what’s available. The S&P500 isn’t the market, nor are all stocks, nor all stocks and bonds. No matter how “passive” you try to be, you’re never truly buying “the universe” and are ultimately actively deciding what to include and omit. There’s simply no easy and cheap way to be passive in the truest sense of the word.
2. People may not have the goal of the average of all financial asset returns. Sometimes the average return is negative, and the passive return will simply be less negative than their active counterpart. If you cannot afford to lose money, there are better options. Or, you may be investing to reach a specific goal and willing to take more risk to achieve a higher return. Again, better options exist. When you consider what you want to achieve, choices should be made that deviate from being passive.

Still, the strongest argument against passive investing is that its central tenet is flawed. Costs absolutely matter, but it is not the only thing that matters. Would you apply the “only cost matters” standards to any other purchase? Would you buy a car or house simply because the transaction fees were low or non-existent? No matter the quality or price? Of course not. But, people are lining up to invest in certain ETFs solely because fees are cheap without any regard to what the underlying ownership represents or the price paid. Passive means buy a little bit of everything, because the market is smarter than you. Not understanding where your money is invested, all in the name of being passive, is not the answer and may prove disastrous.

Active Investing

On the other end of the debate spectrum you have active investing, which also starts with a compelling premise: you shouldn’t indiscriminately buy because it matters what you own and how much you pay.

The active investor believes that not all financial assets are created equal, and behind every security there is a unique investment with its own characteristics, risks, and opportunities. The market is not always correct in pricing this investment, and it’s possible to form your own conclusions about what it’s worth, invest with conviction, and prosper over time.

You need only to look at short-term market prices to realize how flawed they are. Take the largest market cap company Apple for example. In the last year, it’s market cap has fluctuated between ~$470 billion and ~$740 billion. Call me crazy, but I don’t believe in the omniscience of the market when the stated value of one company can vary by $270 billion within one year.

Market prices are general consensus approximations, and by no means perfect. However, to be active and succeed, you need to have the market be wrong, be able to convince yourself the market is wrong, invest, and believe the market will self-correct in a reasonable time period. Additionally, you need to be right to such a great extent that it overcomes all costs associated with active selection: the time, the research, the transaction costs, and taxes. This is by no means easy.

Engaged Investing

Few decisions come without trade-offs. Neither passive nor active investing are perfect solutions. The good news is it is not an all-or-nothing decision. It’s possible to invest by taking the principles of both sides of the debate. At M1, we call this approach engaged investing and believe it’s the most reasonable position to take.

Engaged investing takes the following point of view. Costs matter, and all else being equal you should minimize all costs (commissions, management fees, your time, and taxes) as much as possible. However, costs are not the only thing that matters. It also matters what you own and why you own it.

Your money should be invested at all times to maximize its worth, but you should understand where it’s deployed so it matches your goals, your values, and beliefs. You do not need to be an expert whatsoever, but this is your hard-earned money, so you should not feel that you’re in the dark, investing indiscriminately. Only by being engaged will you understand potential outcomes and not exhibit the worst investing behavior of all, overreacting to short-term noise.

The M1 system is built for this type of engaged investing. We eliminated fees and commissions to provide a completely free platform. We automate buying and selling for you so the time required to manage your money is minimized. However, you have full control over where your money is invested. Like I said, this is your money after all. You can participate in your portfolio construction to the extent you feel comfortable, using expertly designed Pies, doing it all yourself, or any combination in between.

M1 is built for the best of both worlds: active selection but passive management. If you care about your money, have a perspective on where it should be invested, and want to enact your plan as easily as possible, M1 is your solution.

Brian Barnes
Founder & CEO, M1 Finance