Starting out as an investor can be anxiety-provoking – even when you have an investment strategy, never mind when you don’t. In fact, investing in the stock market can be just like gambling without well-informed investment strategies. And whilst that may come with a bit of a thrill, it’s also incredibly risky – which isn’t exactly the ambition when it comes to long-term growth for your money.
Nerves are natural when you start something new. Even though investing has worked out pretty well so far for me in the years since I started, I still remember the feelings of hesitation and second-guessing myself.
The thing is when you’re just starting out there are decisions to make not just about how much you invest, but how you invest your money too. You may fall into the camp where you are happy to buy stocks on your own (I admire your enthusiasm), or you may be the polar opposite; and are desperate to find an expert that can build complex investment strategies for you.
This is the difference between passive and active investing, and whilst neither is necessarily right or wrong, there are a few considerations to bear in mind from the outset.
For example, you’ll want to understand the risks, costs and potential rewards of each approach. And if you read on, you will also find out that there is a healthy balance between these two points that anyone can use as their investment strategy.
Everyone is a genius in a bull market
A bull market is the condition of a financial market in which prices are rising or are expected to rise. It’s most often used to refer to the stock market, but can be applied to anything that is traded – such as bonds, real estate, currencies, and commodities. A “bull run” is when this rise keeps going over an extended period of time – and that’s exactly what we’ve seen in the last few years.
In fact, the latest bull run of stocks has supercharged excitement around investing – and at times like this, it will seem like you don’t even need an investment strategy.
It almost feels like you can pretty much just pick some stocks you like the look of – consider all the cool innovative companies out there right now, such as Tesla, Apple, Virgin Galactic – and run with it.
So in such circumstances, it can often feel like you can make no wrong investment decisions. If you had picked any 10 stocks and 10 cryptocurrencies you will probably have watched them trend up through the course of 2020 and 2021.
Plus, websites and apps such as Freetrade and Robinhood have made it even easier and accessible for anyone to buy popular and exciting stocks. This is magnified by social media and it can be easy to get FOMO (fear of missing out), when it comes to the prospect of making a quick profit.
But it is often said that ‘everyone is a genius in a bull market’ and it can be thrilling to get in on the action, in the hope of accelerating your returns.
….until the next stock market crash
All the hype can quickly sour if the market takes a downturn and falls into a bear market; a “bear market” or “bear run” is when a market experiences prolonged price declines.
It typically describes a condition in which the prices of securities (like stocks, bonds, or options) fall 20% or more from recent highs amid widespread pessimism and negative investor sentiment.
For many investors bear markets are the stuff of nightmares – especially if you’ve invested in individual stocks only to see them go bust. It’s also when you really, really want to have an investment strategy.
Do you need to be an expert to build an investment strategy?
You might now be thinking that you need to be an expert to build yourself a comprehensive investment strategy protecting you and your money from a bear market. Recessions and economic crashes have certainly made the idea of investing intimidating when we think about dramatic financial losses.
But according to the 10,000 hour rule as promoted by Malcolm Gladwell in Outliers; the key to achieving expertise in any subject domain is to reach 10,000 hours of practice. If we’re honest, many of us probably don’t have that amount of experience just yet. Nor do we necessarily want to dedicate ourselves quite so thoroughly to learning all about complex financial strategies all at once.
Therefore, one option is to consider looking at fund managers – experts who should have investment strategies that will allow them to pick stocks that will give you strong returns over time. After all, intuitively, you would expect that someone who has studied and actively put the hours of work in, should be able to beat the market.
In theory, the investment strategy of avoiding falling stocks, and buying into the risers seems plausible, right?
Most investment strategies can’t anticipate the improbable
The problem is that the market is chaotic and unpredictable. It can trip up even the savviest of investors – including professionals.
And unfortunately, many individual investors panic sell as the market falls and buy back in as the prices start to recover; which significantly harms their returns. This is partly because you cannot anticipate how quickly the market will fall or bounce back. For example, at the start of Covid-19 the market fell at a record pace of 30% in just 22 trading days.
But, historically, the economy is usually very robust and tends to bounce back from bear markets, and often the period following a bear market is incredibly strong.
Why do so many investors fail at beating the market?
The job of an active fund manager, supported by a team of analysts and researchers, is essentially to choose investments that beat the stated benchmark index. A benchmark Index is a group of securities used in measuring the performance of other stocks or securities in the market. The Dow Jones Industrial Average, the S&P 500, or the Russell 2000 are examples of benchmark indexes.
In a nutshell, a manager will ‘actively’ buy, hold and sell stocks to try to achieve their goal of beating the benchmark. This is, as mentioned earlier, known as active investing.
However, here’s the rub. Did you know that 90% of active fund managers underperform against their benchmark index over 20 years?
Yep. 90%. Not exactly a good result.
And according to the SPIVA: 2020 Full Year Active vs Passive Scorecard; fund managers underperforming their respective benchmarks is a consistent finding across all asset classes, cap sizes and domestic or international markets.
For example, the best-case scenario for US Equity funds was that only 75.91% of fund managers underperform for ‘small cap value stocks’. These are companies with $300 million to $2 billion in market capitalization, which are perceived as underperforming against their fundamental performance metrics (see, value stocks).
As you can probably imagine, you would have to be pretty lucky to have selected one of these 763 funds with an investment strategy that actually beat the market.
Why do so many actively managed funds perform so badly?
It’s a good question, especially when the impact of their underperformance is so significant.
One study by the University of California found that of 66,465 households between 1991 to 1996, those with fund managers making active trades earned an annual return of 11.4%, while the market returned 17.9%. That’s a loss of 6.5% per year for active investors compared to their passive investing counterparts.
It is safe to say that itchy fingers and stock picking impair returns – and one of the primary reasons many active investment strategies fail is that the market is unpredictable.
Take the S&P 500 as an example. Despite producing an average annual return of 10%, many of the original firms in this index such as Bethlehem Steel, Union Carbide and Eastman Kodak have declined.
On the other hand, new firms such as Intel, Microsoft, and Wal-Mart have taken their place. In fact, when you compare the S&P 500 firms that have survived from the original 1957 to 2003 list only accounted for 31% of the index’s market value.
The fact is that large-cap companies that have been dominant for years – if not decades – collapse frequently. Just look at the Arcadia group (Topshop, Topman, Miss Selfridge, Dorothy Perkins), which fell into administration in 2020; or Carillion in 2018, which collapsed under a £1.5b debt pile. When companies so huge can fail, of course there’s unpredictability and uncertainty in a market.
From Obscurity To Market Dominance
By contrast, stocks that seem obscure now may rise to dominance in six months to a year. And failing stocks can turn things around against the odds too.
As a result, actively managed funds do not capture these rising stocks. For example, Moderna is being added to the S&P 500 this year; an event that might not have happened if not for that little old thing called the global pandemic.
You can also consider the likes of Uber or Spotify – both of which disrupted the markets in recent years.
Or consider Tesla. Tesla’s share price in August 2010 was $3.82, as of June 2021 it’s $623 and a leading stock in major indices. In the years preceding you would have been laughed out the door for trying to build an electric car. Now there is an electric car revolution happening.
However, for all I know by 2022 Tesla could go bankrupt and investors would lose significant amounts of money.
Having an investment strategy that can capture these risers is extremely difficult.
Moreover, whilst there’s also nothing to stop you from investing in rising companies individually, there are often high or complicated fees associated with the trading of individual stocks.
Some websites will charge a flat £12 for any trade regardless of its value – often on top of platform fees – whilst others may charge nothing for the trades themselves but catch you out with withdrawal, currency exchange or inactivity fees. All of this can add up to be very expensive – which isn’t what you want when the aim is to grow your wealth rather than spend it.
What can you do to improve your returns?
To put it in somewhat simplistic terms, the aim is to build an investment strategy that will allow you to capture the recovery, whilst allowing you to maintain losses during the bear market.
As I mentioned earlier, in 2020 the market fell by 30% in 22 trading days. This drop was driven by investors panic selling and avoiding stocks – which you can see when you look at the Vix Index (also known as the fear index).
As it spikes, the stocks prices fall. And no wonder. I’m sure you’ll remember how much fear and uncertainty there was in everyday life at the start of the pandemic, never mind the stock market.
At the time, I personally thought we were in for a prolonged and intense bear market – I’m a glass half full type of person – and many people seemed to agree. There was talk of V and W shaped recoveries; theories around how markets would react to first and second waves.
As a result, there weren’t many investment strategies that would have anticipated the speed of recovery – especially after the market fell at that intensity. Certainly, I’d never have thought in early 2020, stocks would surge the way they did for the rest of the year.
When investing, your capital is at risk.
Passive Investment Strategies
At this point, you will probably be wondering what on earth can you do, if even experts can’t seem to get it right.
How do you capture bull market runs and winning stocks, endure bear market losses and failing stocks; all whilst keeping your costs low?
The answer is actually quite simple.
It’s to use passive index investing strategy.
So let’s break it down. An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index. For example:
- The S&P 500 tracks the top 500 companies in the US stock market
- The FTSE 100 tracks the top 100 companies in the UK
- EURO STOXX 50 – 50 large blue chip companies in the Eurozone
An investment strategy that simply tracks one or more of these indices is referred to as passive investing. There is no active buying or selling of individual stocks.
Following just one index can give you significant diversity in your portfolio by covering thousands of individual stocks. However, there are also funds known as ETFs (exchange traded funds) which allow you to track multiple indices at a time. These are what robo-advisors and wealth managers like ikigai use, creating portfolios of ETFs that you can easily invest in and track.
For example, unlike individual stocks, an index that tracked the US stock market has provided strong sustainable long term returns; even through various pandemics.
Likewise, despite all of the volatility in 2020 if you would have tracked a simple index such as BlackRock’s iShares Core S&P 500 ETF you would have a positive return of 18.38%, by the end of 2020.
The best investment strategy for long-term investing success
Ultimately, aiming for reasonable rather than perfect seems a good recipe for investing success. A passive index fund investment strategy is one way to invest by that philosophy.
Regardless of whether or not index funds outperform active managers in the future; they still offer peace of mind, a good dose of logic, and reduced cost. These constitute the perfect investment strategy for me on an individual level. Makes sense right?
Plus, if Index funds continue to perform as they have done historically, then they are likely to form part of a successful investment strategy in the future – one that secures positive long-term returns, which is pretty much what we all want when investing.
Ultimately, you don’t need the optimal investment strategy to build wealth, you just need to be average.
As mentioned, historically the average stock market return is 10-11% despite bull markets, bear markets and pandemics. So whilst many investors become preoccupied by making the perfect decision, it’s not really worth the anxiety. And yes, it’s easy to become paralysed by uncertainty or to worry about making a bad investment decision – that’s only natural, especially if you’re just starting out.
But in reality, it is inaction that can be most detrimental to wealth. By aiming to make average decisions and average returns, there is often more freedom to take action.
When investing, your capital is at risk.
The benefits of an index fund approach outweigh active investing
The benefit of maintaining an index fund based investment strategy, is that you will ultimately capture cool companies such as Tesla as they rise through the index.
It doesn’t matter who comes into the index or how fast they rise. You will benefit from their growth.
In the same way that if a company falls through the index you will automatically cleanse them out of your portfolio.
Not only is this efficient in terms of returns but also in terms of cost. Actively managed funds often also demand higher fees due to the human resource (e.g. analysts) and the transaction costs associated with buying and selling individual stocks. Passive funds don’t have these resource costs, so they’re more affordable overall.
Ultimately, you can save money, time and energy simply by letting the market index do what it does naturally. It’s like natural selection – you’ll end up with the strongest stocks that outcompete the competition in your portfolio.
If you look at the historical data, by trying to outperform the market by selecting an actively managed fund, it’s likely you’d have underperformed against the benchmark index.
The more optimal investment strategy in terms of both cost and portfolio optimisation, would have been to aim for distinctly average returns. By tracking the index you could have outperformed 90% of funds. So ultimately, low cost, passive investment strategies would have actually helped beat expert active fund managers.
Moreover, you would have ended up with above-average returns. This is compared to the majority of funds – and all by simply tracking the index and being distinctly average.
So that’s why when I think about my own passive investment strategy, I look for a company that offers:
- Professionally managed investment portfolios (e.g. index fund based approach)
- No minimum investment
- Regular rebalancing and reinvesting of dividend
- Low or no management fees, where you only pay low custody and product fees
- No entry or exit fees
Perhaps that same approach is one that can give you some food for thought as you start your investing journey and build your wealth too.