A heated debate over the benefits – and drawbacks – of active and passive investment management has been a constant in the investment world for years. Supporters for active investment focus on the potential for high returns, while passive investment fans focus on low fees and simplicity in portfolio construction. At Jones Hill, we understand the need for both, but we want to shed some light on the differences.
Confused about how active or passive management fit into your investing goals? We’ve got you covered.
The Lure of Active Management
Active investment managers put together a mix of investments meant to outperform the broad market. They may look at economic factors, sector or company research, and market trends to pick and choose which investments to include in a portfolio. These strategies are based on one tempting principal: to beat the market (or appropriate benchmark).
While active management is attractive on its face, the strategy comes at a cost. Actively managed funds are more expensive than their passive counterparts which ultimately eats away at your returns. To add to the pain of active management, most managers fail to outperform the market – especially when it comes to core holdings like large company stocks. If you don’t feel like spending your time chasing returns, active management probably isn’t for you.
Logic in Passive Management
On the flip side of the investment coin is passive management – a portfolio strategy that uses simple tracking of an index to generate investment returns. Passive managers don’t try to reinvent the wheel; instead, they select the same stocks found in a particular index, for instance, the FTSE 100, and put together a portfolio that mimics those holdings.
Because passive management doesn’t include in-depth research or ongoing buying and selling in an attempt to boost returns, investments here are much less costly. Instead of focusing your time and energy on chasing unrealistic returns to make up for fees, you can sit back, relax, and know your investment is using proven logic to give you a respectable return over time.
Who Wins the Investment Debate?
Both active and passive investment styles can help you reach your investment goals, but there is a clear winner in certain situations. Passive investments are a smart choice for your core holdings since history has shown us that active investments simply don’t live up to the performance hype. However, adding low-cost active investments as a small portion of your portfolio gives you access to specific sectors or certain market trends, potentially enhancing performance.
At Jones Hill, we are strong supporters of the low-cost, sound investment strategies represented by passive management styles. But we also understand how active management can play a small part in your overall portfolio design. If you want an expert to help you navigate the world of active versus passive investment strategies, contact us today.
Well, “the risk tolerance chat” is the investment equivalent of the “birds & the bees chat”, important stuff to say the least!
Properly understanding your risk tolerance allows you to be invested in line with your goals and objectives instead of lying awake at night worrying what your investments are up to.
Investment risk and risk tolerance, you’ve probably heard tons about it, but might still find yourself scratching your head thinking.. “what on earth is it?”
What On Earth Is Risk Tolerance?
Risk tolerance is how much risk you can handle in your portfolio and is determined by your investment goals. For example, Mrs Cautious has modest financial goals and a long time to achieve them, therefore she doesn’t need to take on much risk and would likely have a low risk tolerance. After all, why take more risk than you need to?
On the other hand, Mr Risky has more ambitious goals and he’s in something of a hurry (think Friday evening rush hour commuters). Mr Risky is more likely to hit the gas and cut a few corners because, in his view, the reward is worth the risk.
Understanding where you sit between Mrs Cautious and Mr Risky is the art of risk profiling.
Mr Risky Meets Mrs Cautious
But what if you have the needs of Mr Risky but the personality of Mrs Cautious? For lots of people, the answer is just to invest in riskier stuff, right?
Unfortunately not, and this is where we find a lot of people get stuck and worried about what their investments are doing (Up.. Down.. Up.. Down).
If you’re in this situation, don’t jeopardise your nest egg. Instead, consider revising your investment goals to something a little more modest (do I really need 2 weeks in Fiji?), or putting a few more quid into your monthly savings plan.
The Behaviour Gap
For years there have been attempts to simplify the process of identifying risk tolerance by using questionnaires and other tools, but the truth is there are no shortcuts (listen up Mr Risky).
One reason for this is the difference between what we think we would do in a particular circumstance and what we would actually when that circumstance arises. This is called the “behaviour gap”.
For example, in the annual fire drill at the office, everyone knows not to fetch their coat / briefcase / favourite stapler, but we just can’t help it, we just need that stapler right?
This is the behaviour gap in action, we know what to do when the fire bell rings, but when it happens, we go searching for our belongings - and that’s the risk tolerance conundrum!
In an investment context, the equivalent is sitting in your financial adviser’s office, calmly informing them that you can live with a market fall of, say, 20%, but when you start to see red, the first thing you want to do is pick up the phone and scream SELL, SELL, SELL!
At Jones Hill, we realise that properly understanding your risk tolerance is an important part of the financial process. That’s why we ask searching questions and listen attentively, so that we can design a portfolio that’s just right for you.
In the world of investing, we all should consider a few things before picking where to park our hard-earned money. Questions about how much volatility you can stomach, how long you will invest, and the purpose behind the investment are common, but if you’re like most investors, some attention is given to performance. And so it should be!
But is past performance the best indicator of future performance? Based on research and experience, our vote is a big NO!
A Major Player in Fund Performance
It’s easy to be drawn to high performing funds. Who doesn’t want an impressive rate of return – which may or may not come with some bragging rights? Despite the appeal of double-digit earnings, a handful of studies show that past performance isn’t a real indicator of future reward. In fact, the biggest predictor of a fund’s performance is cost.
Every fund has a built-in cost of doing business, known as the expense ratio. Portfolio managers are paid to create and maintain a bundle of various investments within a single fund, making it easy for you as the investor to participate in a well-rounded, diversified investment. The expense ratio pays for that convenience by reducing your total return.
A recent study by Morningstar, the leading global research provider on investments, broke down the importance of costs when it comes to picking your investments. The data reveals that across all asset classes, the least expensive funds outperformed more costly options each and every time.
Staying in Control
So how do you make sure you stay in control of your investment portfolio’s overall cost and total performance? Start with your investment style. Active funds, or those which chase returns in an attempt to outperform the market, have higher costs than their passive counterparts. Despite the appeal in terms of performance, research shows that active funds do not consistently provide higher returns over time (that’s before and especially after costs!).
That’s because chasing performance is less about skill and more about uncontrollable luck.
Passive investments – those which track an index in an attempt to reflect the performance of a specific market – have far lower fees, leading to less drag on your total return. Investment managers who follow a passive management style don’t get caught up trying to beat the market, but instead, they focus on creating consistency and simplicity in their investment choices.
At Jones Hill, we understand that to reach your goals you need investments that perform well over time. Instead of focusing on the hype of outperformance, we help you construct investment portfolios that are low-cost, tax-efficient, and in line with your tolerance for risk – all which allow you to enjoy your life without wasting time chasing unicorn returns.
Contact us today for a discussion about your investment objectives and how we can lend a helping hand.
Unlike “the answer to life, the universe and everything” in the Hitchhiker’s Guide to the Galaxy, this question has no simple answer. However, just as a journey of a thousand miles starts with but a single step, here are three questions that will help to get your relationship with your adviser off on a sound footing.
1. What’s my investment philosophy?
There are several investment ‘styles’. To some extent the styles available will depend on your own and your adviser’s investment philosophy. This is why it’s important to choose an adviser who is sympathetic to your needs and objectives and doesn’t try and shoehorn you into something you don’t understand.
At Jones Hill, we see it as our job to work with you to achieve outstanding outcomes. An important aspect is whether you want to limit investments to companies trying to achieve certain moral or ethical standards, for example by specifically excluding companies that invest in tobacco or weapons.
Whatever you decide, flexibility is key so that if events – whether market or personal – take an unexpected turn, you are not stuck with an unsuitable plan.
2. What’s my risk profile?
Before making a single investment your adviser needs to assess your attitude to risk. In a nutshell, the higher the risk, potentially (not always!) the better the return, but also the greater the risk of failure. How much risk can you stand without it keeping you awake at night?
Well, younger people can generally afford to be a little more adventurous as they have longer to recover from any market setbacks. But for those of us who are a little older, we may want to settle for something a bit safer, which provides more stable and predictable returns. Boring as this may sound, it can be an effective strategy.
No conversation about risk is complete without mentioning Diversification, the golden goose of finance! In essence, diversification means not having all your eggs in one basket, whether that be stocks, bonds or property.
The reason being that sometimes one asset class is hot and sometimes it’s not, but it’s unlikely that all asset classes (property, bonds or equities) will all be swinging the same way at any one time.
3. When can I retire?
The £64,000 question! Why? Because it might be today, in 5 years or 25 years. The problem is, if you don’t know, then you’ll likely just keep plodding on aimlessly when you could have hung your boots up years ago.
The most significant factor in investments is time. The longer you save, the more your “retirement pot” is likely to contain. Whilst this may seem like a statement of the bleeding obvious, the fact is that most people leave it too late to start serious saving. Get ahead of the curve by knowing where you’re heading and when you need to be there.
In summary, make sure that you prepare for your first meeting with your adviser by thinking through the questions and topics you want to discuss, it will enrich the conversation and allow you to discuss the things that are most important to you.
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