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The Recommended Split Between Passive And Active Investing

Passive and active investing are two ways to make investment returns in the stock market. Since my first job in finance, I’ve always actively invested some of my funds to chase unicorns. The question is: what is the best split between passive and active investing?

If you are only a passive investor, you won’t be able to outperform the market (S&P 500 or your index of choice). But at least you’ll save on fees and grow with the market. You’ll also outperform people who don’t even bother investing in the stock market.

However, if you are an active investor, you have a chance at outperforming the market.

You can put some money to work in companies you love whose products you use. You can buy stock in companies that have rejected you. Heck, you can even take a punt at finding the next multi-bagger winner.

It was my active investment in a now defunct Chinese internet stock in 2000 called VCSY, that enable me to come up with a 20% down payment on a San Francisco property in 2003.

There is always a hot stock that could make (or lose) you a quick fortune. They are just hard to find and time right. But that doesn’t mean you can’t try with the proper risk parameters.

Hard To Outperform In The Long Run

Unfortunately, the track record for outperformance isn’t that great for active investors. We know from the data that investing in passive index funds over active funds is the way to go over the long run.

No rational person would keep on investing in an actively managed fund or hedge fund that regularly underperforms its benchmark. Unless you are truly a gambling addict, no rational person will continue to day trade stocks if he is consistently losing money.

Yet, despite the logic, active equity funds still account for about 50% of the entire assets under management of all funds. Why?

The simple reason is that a minority of active equity funds do outperform their respective benchmarks. Thanks to social media, the appearance of people who outperform is also amplified.

When we see such outperformance, this creates hope. We, humans, live on hope as well as a good dose of investing FOMO.

In this post, I’d like to share my thoughts on various splits between passive and active investing in the stock market. I do believe investors should invest some of their capital in individual stocks and/or actively-run funds. I’ll also discuss which type of person is most appropriate for each of the four splits.

Please do not confuse the percentage split between passive and active investing with the asset allocation between stocks and bonds, and other risk assets or your net worth asset allocation.

The split between passive and active investing is part of your overall stock allocation. Although you can clearly be an active and passive investor in bonds and other asset classes as well.

Recommended Split Between Passive And Active Investing

Nothing so undermines your financial judgement as the sight of your neighbor getting rich.” – J.P. Morgan

There is no absolute correct way to invest. In general, since most people are not professional investors, the majority of your investments should be in passive index funds and ETFs. But what should that majority percentage in passive index funds or ETFs be?

Let me share some various passive and active investing splits and describe who they are most appropriate for.

100% Passive / 0% Active

100% passive is for those of you who don’t care about outperforming the benchmarks. You are also happy with getting rich slowly. You are unwilling to take any chances outperforming the benchmark if it means risking underperforming the benchmark.

Investing in an actively run mutual fund with high fees is an anathema. You could give two craps about where the portfolio manager and analysts went to school and their investment track record. Further, you’re a busy professional and/or parent who has no interest or time in following the stock market. Your expertise in making money lies elsewhere.

You love the K.I.S.S. motto when it comes to investing because you’d rather never think about your money. You have so many more important things you want to do with your time.

We know that the average investor only returned 1.9% a year between 1999 – 2018, according to a report by J.P. Morgan Asset Management.

The average investor trades too much, buys too high, and sells too low. The average investor is an emotional wreck. As a result, the average investor would do best to protect oneself from oneself by investing in mostly passive index funds.

You believe the primary way you will reach financial independence is through steady investment contributions over time.

Further, a decent part of your compensation is in the form of your company’s stock. As such, you already have individual stock exposure.

The vast majority of actively run equity mutual funds underperform their respective indices over a 10-year period. Therefore, why bother investing in actively run equity mutual funds or try to pick stocks on your own.

75% Passive / 25% Active

You want to get rich quicker than the average person. My average net worth guide for the above average person motivates you. Therefore, you are willing to take more risks. You believe you can sometimes choose the right funds and the right stocks that will help give your overall investment performance a boost each year.

You are a rational investor who also enjoys following the markets. Perhaps you studied economics or finance in college or graduate school. Maybe you like to regularly read personal finance blogs like this one.

You’re willing to recognize market trends and bet accordingly. You may even have a slight edge in a particular sector due to your occupation.

If an emerging trend seems obvious, you’re willing to invest in a sector fund or invest in individual stocks that should benefit from said trend. You also like to invest in products you use. Nothing feels better than enjoying the product and making money on the product to then pay for the product.

At the same time, you also realize that consistently outperforming your target benchmarks over the long run is impossible. Therefore, you keep three times more assets in passive index funds. Your active investments are in mostly sector ETFs instead of individual stocks.

For a passive plus strategy, you may want to consider investing through a robo-advisor like Personal Capital. Personal Capital will construct a passive investment portfolio with mainly ETFs for you based on your risk tolerance. If you don’t want Personal Capital to manage your investments automatically, you can still use their free financial tools to manage your own money.

50% Passive / 50% Active

A 50% active percentage is the highest percentage I recommend for all equity investors. For those of you who invest for a living, a 50/50 split may be for you. You go to bed at night thinking about your investments. You wake up at least two hours before the market open to read all the news.

Instead of listening to a riveting whodunnit podcast, you’d rather listen to quarterly company earnings calls. Instead of reading a great novel, you’d rather read company financial documents and S-1 filings. You’re hooked on the stock market!

Every day, there are fantastic businesses being built or crazy market manipulation stories to follow. To not look for these potential winners would be foolish. They are all around us. You believe capitalism is the greatest system in the world.

Despite know the odds are against you, we all also suffer from a little Dunning-Kruger (delusion). After all, you’ve got to be a little crazy to believe you can consistently beat the odds. Yet, there are people who do.

For those of you who have at least 10 years of investing experience, who have at least beaten your target benchmark for at least five years, who have the time, and who simply love the process of investing, a 50/50 split may be appropriate for you.

Average returns by asset class from 1999 - 2018Average returns by asset class from 1999 - 2018

A 50/50 split might also be appropriate for younger investors (<30 years old) who don’t have as much to lose. It’s best to learn with less money whether you are a good active investor or a bad active investor. If you find yourself to have investing acumen, you can gradually build up the absolute dollar amount and percentage.

>50% Active, <50% Passive

You’re a professional money manager who picks stocks for a living. You’re also required to have skin in the game by investing a percentage of your bonus or salary into your fund. This way, you feel the pain of your losses and the glory of your wins. Many hedge funds require its employees to invest this way.

You’re also someone who loves everything about the stock market. Investing doesn’t give you stress. It brings you joy! How the heck are you ever going to find the next Google, Facebook, Amazon, Tesla, Microsoft, Dominoes Pizza (!) if you don’t actively pick stocks?

If you are financially independent or have other means of generating income, it’s easier to take more active investment risk. For example, you might operate a profitable lifestyle business or have a large trust fund. You also may not have kids.

You’ve got a lot of pride. You believe that if you can’t outperform the market, then what good are you as a finance professional? It’s important to constantly prove your investment prowess on a meritocratic battlefield. You don’t want to be one of those guys spouting off investing advice with a small portfolio that is perpetually underperforming.

Since most of us are not professional money managers, trust funders, or have profitable lifestyle businesses, I don’t recommend having more than 50% of your investments in active funds and individual stocks.

Recommendation For The Average Investor

After going through all the different splits above, I say the average investor should have a stock investment split of 90% passive and 10% active. For example, if you have a $1,000,000 stock portfolio, invest $100,000 in individual stocks and $900,000 in index ETFs. Even if you lose all your active investment money, which you likely won’t, you’ll still be fine.

With the 10%, you can try and pick winners with no expectation that you will outperform. Invest in what you know, use, and earn. Do you really think investing in Apple computer is going to make you go broke? Probably not with its $100+ billion in cash. But you might lose a lot in a Gamestop, an unproven biotech company waiting FDA approval, or an over-leveraged marijuana company.

As you get more interested and more experienced with investing, you can gradually increase your active investing percentage. I wouldn’t go greater than a 50% allocation towards active investing. The historical performance numbers just aren’t our friends.

Further, remember that if you work at a company and get company stock as part of your compensation, these shares can count as part of your active allocation. These shares could work out very well for you if you work at a company like Apple. Or these shares could hut you if you work at a company like Enron.

Relying too much of your wealth on your career can be dangerous. If your company goes down, not only will your company shares lose value, you may also lose your job.

As an investor, you must quantify your risk tolerance. Once you have quantified your risk tolerance, you should have no problem working for the amount of time necessary to get back to even. If you do have a problem spending that required amount of time, your risk exposure is too high.

My Current Active And Passive Investing Split

The Recommended Split Between Passive And Active InvestingThe Recommended Split Between Passive And Active Investing

Since 1996, when I opened up my first online brokerage account with Ameritrade, my greatest wins and my greatest losses have all come from investing in individual stocks. As a young man, I didn’t mind my big losses because the absolute dollar amounts lost weren’t very big.

From 1996 – 2009, I predominantly invested in individual stocks. After all, I worked in international equities at two major investment banks. My income was growing and I felt I had an edge.

But after the financial crisis, my desire to make money quickly dissipated because I had lost so much money (-35% in six months). My desire to protect my capital and avoid experiencing as much financial pain came to the forefront. Further, I had started thinking about ways to escape finance since it was no longer fun.

Today, my split is roughly 75% Passive / 25% Active. I continue to own a bunch of individual tech stocks and other names for the past 15+ years. After a couple years of living in San Francisco, I realized the real growth was in tech, not banking.

Owning Bay Area real estate and tech stocks were my main two ways of participating in the tech boom. As I said in a previous post, I was too untalented to get a job at a growing tech company.

Always Going to Actively Invest Some Money

After all these years, I still enjoy following all the economic, political, and company-specific news that could affect share prices.

However, as a dad to two younger children now, I no longer have the time to analyze cash flow statements. Listening to management conference calls is a thing of the past.

I like the combination of having a core S&P 500 index fund, some sector ETFs, and individual stock names that I use and love. It’s my “Passive Plus” strategy.

I also sold my actively managed SF rental property in 2017 that was giving me nightmares.

35% of the proceeds were invested in dividend ETFs and single-stock names, 35% was invested in California municipal bond funds, and 30% was invested in a portfolio of real estate crowdfunding projects. It feels great to earn income passively.

My main financial goal in my 40s and beyond is capital preservation. The bull market we’ve experienced since 2009 has been greater than I had ever expected. Further, I also want to buy as much time as possible. If I can grow our net worth by 10% a year with minimal stress, I’ll be ecstatic.

U.S. Stock Market Ownership Is Diversified

There’s a lot of talk about passive investing being in a bubble. However, take a look at this U.S. stock market ownership graph. If we say ETFs make up the majority of passive investing, then passive investing does not dominate stock market ownership.

US Stock Ownership - passive and active investingUS Stock Ownership - passive and active investing

The vast majority of people should still have the vast majority of their investments in passive investments. Passive index investments have low costs and it’s very hard to outperform the indices.

Investing mostly in passive funds doesn’t mean you should be a zombie and just invest 100% in a particular passive equity index fund. You should diversify your investments to match your specific financial goals and risk tolerance. You should also review your investments at least once a quarter.

Find a way to get rich slowly through passive investing. It’s also worth finding ways to get rich quickly through active investing as well. It’s up to you to find the right split between passive and active investing depending on where you are on your financial journey.

Related: The Best Way To Get Rich: Turn Funny Money Into Real Assets

Readers, what is your current split between passive and active investing? What do you think is the appropriate split for the average investor? How do you plan to get richer than the average passive investor if 100% of your investors are in passive index funds?

Please note, I firmly believe in the long run, the vast majority of day traders will blow themselves up. If you are to invest in individual companies, do your fundamental research and invest in what you believe will be long-term winners.

Source: The Recommended Split Between Passive And Active Investing

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Written by Financial Samurai

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