There is considerable debate on whether investors should apply an active or passive investment strategy. It can be hard to justify an actively managed strategy in an up market. In a bull market, anyone can buy an index fund and do well. But, one of the benefits of having an actively managed portfolio is that the manager not only strives to achieve a rate of return needed to meet your financial goals, but also manages the risk taken to get that return. Generally, a conservative, actively managed portfolio will not go up as high as the market on the upside, but on the downside it may not go as low as the market because you may be taking on less risk by buying higher quality investments. Over the long term, you should do better by taking less risk because you will spend less time playing catch-up after a downturn.
Humans by nature are risk averse. We’re also prone to making irrational decisions. When the market is falling, the general reaction is to withdraw your money to protect it. However when the market has a huge decline, it is usually followed by a huge rebound. If you are out of the market and miss the best days of the rebound, you could miss out on nearly two-thirds of your return. Unfortunately, no one can predict when those best days will be, which makes timing the market virtually impossible.
At Henssler Financial, we use the Ten Year Rule to keep investors in the market to capture those best days. The Ten Year Rule keeps money you will need to spend within the next 10 years in investments that were designed to preserve the principal. This is designed to eliminate the concern of having to sell your investments during a downturn in the market. If you have no reason to sell and you feel that you and your adviser made sound investment decisions based on fundamentals of the company, then the investment is still viable regardless of the short-term movements of the market. The tangible value of the companies has not gone down—it is just what the market shows at this point in time. If you sell, you realize the loss. If you ride the storm out, your stocks have the potential to rebound. Having an adviser in your corner can help you avoid making irrational decisions that could hurt you in this respect.
With a passive strategy, you can simply buy an index mutual fund or exchange-traded fund and eliminate the individual stock selection process. An index fund is modeled after a particular index, owning shares of all stocks in the index at pre-determined weights, usually based on market capitalization. By investing in an index fund, your investments will never perform better than the market; however, you should also never do worse.
There are two primary downsides to this passive strategy. First, when buying an index fund, you’re buying all the stocks within that index, both high quality and low quality. Meaning that you may be taking more risk than buying a portfolio of only higher quality companies. Secondly, you participate in buying high and selling low—the exact opposite of what Investing 101 taught you—because of the way index funds work. As a stock’s price rises, its market capitalization also rises, which in turn, means that its weighting in the index increases, as most indices are market-capitalization based. To maintain the objective of tracking the index, the fund has to buy more shares of that stock to reflect the increased weighting; therefore, the fund buys more shares when the price is high.
Should investors want to beat the market? Both investors and advisers compare their performance to the overall market to benchmark how they are doing. But that should not be the end of the comparison. You have to consider the risk you are taking to achieve those returns. To be successful, you do not need to beat the market. You only need a growth rate that will allow you to achieve your financial goals. That optimal rate of return is driven by your financial plan. With a plan in place, it gives you and your financial adviser an idea of what return is needed to achieve those goals. Quite often, it is a realistic rate of return; therefore, there is no need to take on the risk required to chase a return of 15% a year.
If you have questions regarding your investment strategy, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
