• Thu. Jan 21st, 2021

Passive Or Active Investing Which Way Will You Earn More

Passive Or Active Investing Which Way Will You Earn More

You want to jump into the stockmarket all the tips and coursed advertised. Endless advice and how to time the market and get rich quicker.

Academic studies of US mutual fund performance show that even professional investors have difficulty out performing market benchmarks, and studies show that individuals lag market averages when they trade stocks or mutual funds without fully understanding what they are doing.

Reasons Why The Market Outperforms The Individual

In an academic study by Brad Barber and Terrance Odean  they found that individual investors experience reduced returns when they traded their own stock. The reasons being,

  • Over confidence, a person being confident in their decision without the knowledge of what they are purchasing.
  • Over confidence leads to frequent trading the costs of a trade take a nice chunk out of your profits.
  • Another reason when you sell you have to pay taxes on your sales this similiar to what we wrote about in our article The Obsession Of Keeping Investment Costs Low Explained takes a huge bite into what you can reinvest.

The Hard Facts And Truth

Barber and Odean write in their study The Courage of Misguided Convictions: The Trading Behavior of Individual Investors

After examing 66,465 US households that had trading accounts from 1991 – 1996 period, the market returns were during this period 17.9%. Households that traded were 16.4%. The households that traded the most earned an annual return of only 11.4%.

(risk-adjusted returns mean comparing category of risk lets say high riskinvestment men compared to women)

Barber and Odean further found that men are more active traders than women and thus leading to an average earning of 1.4% lower risk-adjusted returns.

Single men trade more frequently than single women and earn 2.3% lower risk-adjusted returns than those earned by single women.

Further Proof

In a study that examines the returns of Taiwanese investors. Using a complete trading history of all Taiwanese investors, found that the aggregate portfolio of individual investors suffers an annual performance penalty of 3.8%.

They traced the shortfall to individual investor’s aggressive trading orders.

They further examined day-trading in the Taiwanese market for the years betwean 1992 – 2006 and found a return spread of 70 basis points per day between the top performing and bottom performing day traders. That is less then 1%/

Even more shocking less than 1% of the total population of day traders is able to predictably and reliably earn positive abnormal returns net of fees.

Individual Investors And Mutual Funds

John Bogle in his book the Little Book of Common Sense Investing examines the performance of mutual fund investors.

Over the 1980 – 2006 period the US market return an annualized return of 12.3%. Over this period, the average equity fund produced an annualized 10.0% return. Individual investors earned  an annualized 7.3% return.

What About Timing The Market

Mark W. Riepe, from Charles Schwab, tests perfect market timing against four other investment strategies in his article, Does Market Timing Work?The study tracks the performance of five hypothetical long-term investors following one of the five following  investment strategies

  • Perfect timing: investing at the market low each year;
  • Invest immediately: invest at the beginning of each year;
  • Dollar cost average: invest in 12 monthly installments (also mirrors payroll installment investments in a 401-k type retirement plan);
  • Bad timing: invest at the market high each year;
  • Stay in cash investments: stay invested in treasury bills.

Each investor received $2,000 at the beginning of every year for the 20 years ending in 2012 and left the money in the market, as represented by the S&P 500 index.

The table below shows the ranking order of performance  and  accumulated wealth over the 1993 – 2012 period for each investment strategy:

StrategyTerminal wealth
Perfect timing$87,004
Invest immediately$81,650
Dollar cost averaging$79,510
Bad timing$72,487
Stay in cash investments$51,291

The totally unrealistic strategy of perfect timing will always occupy the top place in the ranking. The measured period was also one which included a realized equity premium return over cash investments.

The study then examined 68 rolling 20-year periods dating back to 1926. In 58 of the 68 periods, the ranking order was exactly the same. In only one period did investing immediately fall to the fourth ranking (in 1962 to 1981, a period of weak equity markets). However, during that period, fourth, third and second places were virtually tied.

The study concludes that “the best strategy for most of us mere mortal investors is not to try to market-time at all. Instead, make a plan and invest as soon as possible.”

In Short

In short unless you throw yourself completely in you should just invest and let the market does its magic!

Thanks for enjoying if you enjoyed which I am sure you did share it with a friend!

Binyomin Terebelo

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