The Cost of Active Investing

Chances are, you fall into one of two investing camps: passive or active.

Passive investors like to invest in index funds. They typically buy the entire stock market, or most of it, via funds based on the S&P 500 or the Dow Jones Wilshire 5000 -- and accept average market returns.

In contrast, active investors aim to beat the market, making most or all of their investments outside indexes. For example, they may invest in a bundle of carefully selected individual stocks, or select mutual funds that concentrate on a specific subsector of the market, such as small-cap stocks, energy stocks, or foreign regions.

If active investors have a chance to beat the market average, why would anyone want to be a passive investor? Alas, the question's not that simple; in many respects, passive investing can be hard to beat.

As we've explained for more than a decade now, the vast majority of managed stock funds (more than 75%) fail to do as well as the overall market. Over some time periods, that figure heads closer to 80% or 90%. It's no piece of cake finding a winning mutual fund. (As Shannon Zimmerman has lamented, "8,000 Funds, So Little Time"!)

Below-average returns
According to a study by Dartmouth business professor Kenneth French, investors wasted 0.67% of their return trying to earn superior returns. Over the 26 years studied, passive investors earned an average of two-thirds of a percentage point more than active investors.

Why the disparity? For one thing, active investing means making judgment calls. When active investors make wrong calls, their performance suffers.

In addition, many active investors are very active, trading in and out of various holdings frequently. Frequent trading will generate lots of commission expenses (even though the rise of online brokerages has slashed these costs dramatically). Taxes can also take a bite out of active investors' earnings. Capital gains from investments held for more than a year currently enjoy a lower long-term tax rate (though Congress may change this in the future), but gains held for a year or less are taxed at ordinary income rates -- as high as 35%.

Simplicity
Index funds offer yet another advantage: They're easy. Really easy. Active investing means making decisions regarding where to invest your money, and for how long. You'll have to pick which stocks or funds (or both) to invest in. You could leave these decisions to others, but that can be risky, if your money managers don't have your best interests at heart or simply aren't that good. But with passive investing, you just select one or more index funds, invest in them, and call it a day for years or decades. (Ideally, you keep adding to the investment over time, whether you're being active or passive.)

But still...
Despite all the above, it can make sense to invest actively -- if you're good at finding above-average stocks and funds. Remember that if 75% of managed mutual funds fail to beat the market average, that means 25% of them succeed. Among those, a chunk have outperformed just due to chance. But a subset owe their excellence to skilled managers, and thus stand a reasonable chance of continued outperformance.

For example, the Janus Contrarian (JSVAX) fund sports a market-whomping five-year average annual return of 18.3%, with a relatively low turnover ratio of 28%. (That means it doesn't trade in and out of stocks at a rapid clip, changing only 28% of its total holdings in any given year.) Its top holdings recently included Coventry Health Care (NYSE: CVH  ) , Amgen (Nasdaq: AMGN  ) , and J.C. Penney (NYSE: JCP  ) .

To find winning funds, take a free trial of our Motley Fool Champion Funds newsletter service, which has helped me find a bunch of solid performers for my own portfolio. Its recommendations have been beating the market by more than 20 percentage points. A free trial will let you access all past issues and all recommended funds.

So make up your own mind about how you want to invest. One sensible approach is to engage in both active and passive investing, devoting a big chunk of your portfolio (perhaps most of it) to a broad-market index fund, and then adding some strong stocks and funds to that. Either way, though, I urge you not to avoid mutual funds.

Longtime Fool contributor Selena Maranjian owns shares of Amgen. Coventry Health Care is a Motley Fool Stock Advisor recommendation. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.


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