The Only Three Ways to Invest
There are essentially only three ways to invest your resources. Watch as Envision Wealth Planning President, Bob Bolen CFP®, explains each of the three portfolio management strategies, and identifies the pros and cons of each.
The basic presupposition of active management is that the market is getting it wrong. An active manager attempts to beat the market through security selection or market timing.
The active approach to portfolio management attempts to identify and own the most promising securities before other people do.
There are several hundred methods of active management. If you’re looking at the fundamentals, you can talk about high quality, low quality, valuation differences, growth, value, or management.
Then there’s technical analysis, such as charting or trend following. You can do this at the individual security level, the sector level, or at the market level.
Active management generates higher fees. It takes time and talent to research and track the qualities that you desire for your portfolio, and to implement. If you hire someone to do that for you, then you’ll have to pay for their time, effort, and energy.
Trading costs and taxes are also higher with active management because there tends to be more turnover in the portfolio.
The promise of active management is that net returns will be indexes after these additional costs.
Asset Class Management
An alternative to active management would be, what we call, “asset class management.” Asset class management is grounded in the efficiency of capital markets. Investors employing this approach believe the market works, and that it works well. They believe the market adequately discounts information into the prices of the securities at the moment.
The asset class management approach to portfolio management seeks to capture specific dimensions of risk identified by academic research. This approach minimizes transaction costs and enhances returns through trading and engineering.
Index management uses commercial benchmarks to define your investment strategy. The Standard and Poors Company creates an S&P 500 and the Russell Company creates a Russell 1000 index. You can invest in these indexes as your portfolio management strategy.
The index management approach to portfolio management accepts index-like returns. Employing this strategy requires a willingness to incur transaction costs and turnover in exchange for low tracking error.
When the S&P 500 reconstitutes its 500 stocks the index will reconstitute its index, therefor creating turnover in the portfolio.