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The benefits of passive investment

There are two main kinds of investment strategy: Active and Passive.

Active

The most common investment strategy offered by fund managers is active investing. Active investing means taking investment decisions to try to outperform the market. Usually this requires teams of researchers and managers to take decisions - and thus fees must be charged to cover these costs.

Passive

On the other hand, passive strategies are all about following indices over the long term. They also have managers but their goal is to replicate the performance of an index as closely as possible - rather than making active trading decisions. Passive managers invest in broad sectors of the market, called asset classes or indexes. The underlying reasoning here, is that consistently outperforming the market for the professional and small investors alike is difficult, so why try to do it? Why not minimize operating costs and take the market returns?

Which is one better at the end of the day?

The core of the issue is that active investments use the help of larger teams. Accordingly, they bring higher fees with them... by a few percentage points. This may look small or negligible at first but as time goes, the higher fees affect your annual returns (and therefore your compounding returns) and, as a result, the impact of higher fees can be significant over the long term.

Unfortunately, most fund managers fail to beat the market over a long period of time.

Warren Buffett, the world famous investor and CEO of Berkshire Hathaway, stated in a letter to shareholders: "low-cost index funds are likely to beat most active fund managers" (ok, to be fair, he meant in the long run and in the US).

He even goes further stating: "Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors [...] can destroy the decent returns that a life-long owner of equities would otherwise enjoy".

A debate about the two approaches has been ongoing since the early 1970s. Supporters of the passive management argument include academic researchers and privately funded research centres... while active management is rather favored by larger financial institutions.

At Simplewealth, we believe in long term, passive investments in diversified portfolios are the best way to accumulate wealth over the longer term.