What Kind of Investor Are You?
An active investor is one who seeks to outperform the market, to invest in winners while avoiding losers, and who responds to market dynamics with portfolio repositioning from time to time. The passive investor, on the other hand, is satisfied to just get market returns. The loss of upside potential is balanced by the fact that returns will be no worse than the market. Passive investors may choose index funds, while active investors prefer to own individual securities or actively managed mutual funds.
One advantage of passive investing is the low cost. Active management tends to incur transaction costs and tax costs, and the advice of an experienced investment manager is not free. Some investment managers will beat their benchmarks, others will not, and costs figure into that performance. A 2016 study by S&P Dow Jones Indices suggested that some 90% of active managers missed their targets over various time frames. That may be part of the reason for more and more money moving into passive funds over the last decade. Passive investing also is growing more popular in Europe, but there accounts for only 15% of funds.
Active managers have the flexibility to increase exposure to promising sectors of the economy and to avoid those showing weakness. They may be able to use short sales or put options as hedges against downturns, and they can sell a stock that seems clearly headed for a fall. The index investor necessarily owns all the stocks in an index until a stock is removed from it.
An investment manager may be able to tailor a strategy for tax efficiency, for example by selling stocks that have lost value to offset other realized gains on sales. Interestingly, even hedge fund managers, who are among the most highly compensated of the active investment managers, have a portion of their holding in passive funds, according to Investopedia.
In a rising market, with a strongly growing economy, many investment strategies will look good, including passive ones. But when a bear market emerges, most investors will favor taking steps to preserve capital, and not simply accept a portfolio meltdown.
Preparing For a Bear Market
Bull markets do not last forever, much as we may wish that they did. One defensive measure to take is to allocate more of the investment portfolio to fixed income investments, such as bonds. However, we are still in an era of abnormally low interest rates, in which generating significant income from a bond portfolio is difficult.
When a bear market does emerge, history suggests that the safest stocks are likely to be utilities and consumer staples, followed by health care and telecommunications. See “A tale of two recessions” for more details. At the moment, few if any are predicting a bear market in the foreseeable future. But bear markets don’t often announce their arrival with great fanfare, so the prudent investor needs to stay alert.
A Tale of Two Recessions
This table compares the performance of ten sectors during the bear markets that accompanied the last two recessions. The numbers show the percentage return of each sector compared to the overall market (which was down), not the absolute return of the sector. Numbers in parenthesis are negative.
2000 Bear Market
2007 Bear Market
Source: Singer, “Positioning Portfolios for the Eventual Bear Market,” Trusts & Estates (September 2018).
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