Understanding Indexing, Passive Investing and Active Investing
Raising calves into cattle and selling them is a business. Ranchers spend money to shelter, feed and grow cattle in order to sell them for a profit. Some cattle die before they are able to be sold and some cost more to produce than they end up being sold for. Others become the market ideal, fetching top dollar and maximum profits. If you could invest in this business, what would you do? Would you examine every calf in order to attempt to determine which one will be the most profitable? Would you divide your investment into your top five or ten most promising calves? Would you just invest a portion in every calf, thinking it’s too difficult to predict which calves will grow into the most profitable cattle?
Investing is similar
You can pick and choose which investments you believe will be better than other investments or you can invest a little bit in everything.
According to Google search data the “Dow” or the Dow Jones Industrial Average is the most recognized market index on the planet. Other indices include the S&P 500, the FTSE 100 and the Barclays U.S. Aggregate Bond Index. These indices are baskets of stocks, bonds or other assets designed to represent a segment of the investment market. For example, the MSCI All Country World Index is and index of approximately 3000 global stocks from 23 developed and 26 emerging market countries designed to represent the largest companies in the world. The stocks in the index are weighted in proportion to their market capitalization, which is the total value of the companies determined by multiplying stock prices by the total number of stocks outstanding. There are other weighting schemes, but market capitalization weights are the most common.
An important characteristic of market indices is that the weights don’t reflect any opinion on how good or bad any of the underlying investments are as investments. Another important characteristic is that indices hold every underlying asset in the specified segment of the market. Investment products that mimic the holdings of market indices are called passive investments. Like indices, passive investments do not alter holding weights based on opinions on how good or bad any of the investments are. Fees for these products are typically very low.
If you had an opinion on how good or bad the underlying assets will be as investments, you would probably want to change the weights of the underlying assets from that of the index. You would add to the weights of assets you think will outperform the index and you would subtract from or eliminate the weights of assets you think will underperform the market. There are mutual funds and other investment products run by professional investors that do just this. They pick and overweight assets they think will be better investments and underweight or don’t hold assets they thing will be poor investments. The products typically hold fewer assets than the index. For example, an investment product attempting to outperform the S&P 500, which holds 500 stocks, might hold only 50 to 100 stocks. The more the holdings differ from the index the more the returns are likely to differ from that of the index. To compensate the managers of these products for their time, research and expertise, you pay higher fees. Investment products that attempt to outperform an index are called active investments. If the product outperforms the index by more than the fees, you are better off with the active investment.
It’s pretty common for an asset allocation to contain a mix of active and passive investments. You should tailor your asset allocation to your financial situation, goals and risk tolerance.