Who Wins The Investment Race, The Tortoise or The Hare?

There are basically two investment management styles: passive or active. I view these two styles as the passive tortoise and the active hare.

Why Chase the Active Management Hare?

The hare represents the active money managers who try to “beat the market” by using their crystal ball. They seek to generate impressive returns based on their in-depth (and highly paid) analyses and forecasts of when to buy or sell certain company’s stocks, or when to get in or out of the market and/or its various sectors.

Perhaps because the hare is fast and flashy, it also tends to generate the most media attention. If you pick up a financial journal or surf the web, it’s easy to find “news” based upon active management prognostications. The overwhelming quantity of it all appears substantive, worth heeding. If “everyone” is buying or selling something, it feels like they must know something you don’t, and that makes it tempting to follow the leader. However, in truth, this active style of investing has two serious drawbacks:

1. “Everyone’s” crystal balls are murky. Markets are generally efficient – too efficient to win the proverbial race by trying to outguess them. Whether it’s good news or bad, as soon as something is known by that aforementioned herd of “everybody,” guess what? The market knows it too. That’s because, the market pretty much is everybody. Thus, prices effectively adjust immediately in response to any new information, which means, by the time you (or your actively managed mutual funds) are trying to buy or sell to capitalize on the news, it’s too late. The race already has been run.

2. Crystal ball investing is expensive. Even if you or your actively managed fund could occasionally manage to be ahead of the game by placing some smart bets, it’s important to realize that every attempt costs you money. Every time you or your fund makes a trade, a broker charges a fee for the transaction; whether it’s a good move or a bad one. This means you have to make enough successfully timed trades to overcome the costs of your successful bets, as well as all the unprofitable ones.

Fix Your Future on the Slow and Steady Tortoise

The tortoise, on the other hand, represents the passive management style. The tortoise doesn’t own a crystal ball. He knows that, over time, the markets have generally headed upward rather than downward – at least for those who have stayed the course.

So, the tortoise avoids making investment decisions that are based on active attempts to forecast trends. Instead, he recognizes that the best way to invest in the market is to “be” the market. Whenever returns are earned by “everyone,” the tortoise already is there, slow and steady, patiently waiting his turn. By adopting this buy-and-hold strategy, he keeps costs low, using the science of how markets work to his best advantage.

The tortoise may not grab headline news the way the hare does, but if your true goal is to build long-term wealth, you might want to consider the tortoise-like approach of buying low-cost, passively managed mutual funds. The best passive funds seek to closely replicate the returns of a particular index or similar benchmark with as few costs as possible. A “benchmark” is a widely accepted standard against which performance of particular types of investments or particular investment managers can be measured to determine their success compared to others like themselves. Different types of investments or investment managers are compared against different benchmarks. For example, stocks from large, successful U.S. companies are inherently expected to deliver different levels of returns than stocks from small, stressed-out companies in tiny, emerging markets. So each is held to its own standard, or benchmark, to enable apples-to-apples comparisons for each across the various players in the market.

With passively managed funds, nobody’s getting paid triple-digit salaries to try (and likely fail) to be more clever than the market. Nor are huge costs being incurred to try to develop fancy and ineffective, forecasting techniques. Despite short-term fluctuations, the markets have by and large moved in an upward direction over time.

Passive investing puts you in the best position to capture and keep as many of those long-term returns as possible. Maybe it’s not as exciting to simply stay put during all the market changes, but it’s much more sensible.