Active Or Passive Investor?

An active investor. This title usually conjures an image of an investor who researches the best selection of stocks and buys them at the right price at the right time in order to outperform the average return of the market.

A passive investor, on the other hand, conjures an image of an investor who just buys into index funds with the purpose of achieving the same return as the market.

While my investment philosophy aligns with passive investing, when asked whether I am an active or passive investor, I still struggle to give a consistent answer.

I am a passive investor…kind of.

Maybe the line between passive and active is not so clear after all. Maybe instead of defining in either passive or active, we should define it in varying degrees of passive-ness to active-ness of the investment strategy.

In this article, I will attempt to describe the entire range of passive to active investing using four criteria: Effort required, control over investments, complexity and costs of the investment strategy.

I will start at level 0 where it is the most passive and work all the way up to level 8 where it is the most active.

Level 0

This is a unintentional investor – he might not even realise he is investing because he has never lifted a finger or is aware of it. A portion of his paycheck goes automatically into his government-mandated retirement savings account earning interest. For Singaporeans, think of an employee who is contributing to his CPF. It happens automatically.

  • No control over your investments at all
  • Least effort and least cost
    • fully automated contributions
    • fully managed portfolio

Level 1

This is an investor who approaches a third party to invest passively on his behalf. He needs to chose the right third party and do a one time financial and risk assessment. The third party choses the funds and maintains the portfolio.

  • Very little control over your investments
  • Minimal effort
    • An initial selection of financial advisor or robo-advisor.
    • An initial financial and risk assessment
    • Regular contributions can be automated
    • Fully managed portfolio
  • Low cost. Costs slightly higher than a DIY passive investor (level 2) but lower than actively managed investments

Level 2

This is a DIY investor who believes in passive investment. He just wants to get the market returns and stick to a simple portfolio. After determining his risk, he creates a portfolio either with a simple bond index fund and global index ETF or using a Bogglehead three fund portfolio: one bond fund, one home country index fund and one global index fund. Once the portfolio is done, he contributes to it regularly and rebalances at a fixed schedule or when needed.

  • Full control of your portfolio
  • Some effort required
    • An initial financial and risk assessment
    • Initial research on index funds or ETFs and portfolios (low costs)
    • Regular contribution (Can be automated) and does not believe in market timing
    • Calendar or constant mixed rebalancing
  • Simple portfolio
  • Lowest cost

Level 3

This is the more sophisticated passive investor. He fundamentally believes in indexing. However, he wants to beat the market using factors or with his custom portfolio. So he modifies his index fund and tilts it with factor exposures. He still holds all the stocks in the index, by tilting, he overweights specific groups of stocks, e.g. small cap stocks, profitable stocks, value stocks etc etc… This is no longer pure passive but he still believes in indexing and not timing the market.

  • Full control
  • More effort required
    • An initial financial and risk assessment
    • Initial research on index funds or ETFs and portfolios
    • Modifies his plain vanilla index portfolio to include more factor ETFs or funds. A more complicated portfolio compared to level 2
    • Regular contribution (Can be automated) and does not believe in market timing
    • Calendar or constant mixed rebalancing
  • More complicated portfolio
  • Low cost

Level 4

This is what I call the an ‘active passive investor’. They may be buying passively manged ETFs but do not be fooled. The main difference is that they time the market and they pick and choose narrower or thematic ETFs as if they were stocks.

One example is a portfolio holding various sector ETFs and depending on the economic cycle, they overweight or underweight certain sectors. So when recession indicators are flashing, they switch into defensive or healthcare ETFs. This is what Stashaway is doing.

Another market timing strategy is by buying into country specific index ETF when the opportune time arrives. For example, he may buy into Hong Kong Index ETF when the riot broke out in 2019 or he may buy into China ETFs when COVID-19 paralyses the Chinese manufacturing industry.

Or this could be someone investing in a cloud ETF or a marijuana ETF to speculate on certain trending industries.

  • Full control over your portfolio
  • A lot of effort required
    • Initial financial and risk assessment
    • Constant research into strategic ETFs – sector, country or trend (cloud or canabis)
    • Market timing is involved. Follow market news and trends and buy into areas where the investor thinks there is opportunity
    • Rebalancing or reconstructing portfolio according to market condition.
  • More complicated portfolio
  • Cost is high but still lower than active funds – the underlying ETFs are still passively managed.

Level 5

I call investors at this stage ‘passive active investors’. So these are investors who outsource their investments to actively managed fund manageds to invest on their behalf. They want to beat the market with actively managed funds or ETFs. They may switch from fund to fund occasionally.

  • Very little control because the investor outsourced it to the fund manager
  • Less effort on the part of investor
    • initial selection of actively managed fund or investment manager
    • Monitoring performance of the fund
    • May switch from time to time
  • Low complexity – outsourced to the fund manager
  • Costs are high – active managers are employing active strategies

Level 6

This is the conventional definition of an active investor. They do stock picking and buy low and sell high. This includes the value investors and dividend growth investors. You pick only the best stocks, buy them at the most reasonable price and wait for them to grow to reap the profits

  • Full control over your portfolio
  • Significant effort required
    • Stock analysis (Fundamental analysis) or price analysis (Technical analysis)
    • Selecting stocks to include in your portfolio
    • Timing the market – buying at low prices and selling at high prices
  • Still mainly a buy and hold strategy
  • Costs are high

Level 7

This is the more sophisticated active investor. They employ very complex strategies and hedge their positions. They want to profit in downturns as well in upturns. They buy contracts to buy or sell stocks at a certain price (options) to hedge and make profit within a certain time frame. No longer contented to wait it out, some do not have the patience and would want to make profits within the day by day trading, CFD trading etc etc…

  • Full control and hedging strategies for various outcomes
  • Very significant effort required
    • Same as level 6: stock picking and market timing
    • High speed and leverage to make a quick profit
  • Tend to be speculative
  • Very high risk and reward
  • More complicated strategies: long and short, call and put options, swaps, etc etc…
  • Very costly to implement

Level 8

This is the other end of the spectrum. These investors are called activist investors. While the investor employs all active management strategies, the investor also make strategic decisions to buy out a large percentage of a company to implement significant control and change to the company. Venture capitalists are part of this category as well. They fund companies at initial stages and are involved with managing or influencing the company.

  • Obsessive level of control – from portfolio level down to the individual companies
  • Investor buys into companies and influences (or sometimes manages) the company actions/directions
  • Obscene level of costs – significant amount of capital needed to buy majority share of companies

Conclusion

So which level am I in?

I started as an active at level 6 and slowly moved to level 3. But because I am torn inside, some part of me wants to time the market (the recent drop in markets has been tempting me to buy the dip) and own individual stocks, I end up in between level 3 and level 4.

The point is: we probably will not fit nicely in one or two levels – humans are complicated.

Let me know in the comments whether you would agree with my definition of each level or if I had missed any.

Author: Fatty's Finance

Finance is like health. It becomes an issue if it is not well maintained. I want to help you get back in shape!

Leave a Reply