The stock market or equity market reflects the growth of the country's economy. And, if you want to be a part of the growth, you can get this opportunity by investing in the stock market.
Broadly there are two ways in which you may invest in stocks. First, you may directly buy shares of companies which are listed and traded on stock exchanges. Another way is to appoint a fund manager who invest in stocks on your behalf, for which mutual funds are the simplest way.
Any mutual fund scheme is either actively managed by a fund manager or can be managed by simply passively following any index
Active investment is an investing strategy where investors try to actively pick stocks with an objective of generating superior returns. It is a strategy where investors try to beat a market or appropriate benchmark which is called as alpha – α. Active investors rely on information available to them while making any decision and ignore the overall market wisdom. They commonly engage in picking stocks, times, managers, or investment styles. Active investors who claim the ability to outperform a market are in essence claiming to accurately predict the future. When accurately measured, this is simply not possible. Surprisingly, the analytical techniques that active investors use are best described as qualitative or speculative, largely including predictions of future movements of stocks or the stock market.
Passive Investment or index investing is an investing strategy that tracks an index or a portfolio created based on pre-defined set of rules. The idea is to avoid the adverse consequences of failing to correctly anticipate the future. There is sharp contrast between the behavior of passive and active investment. Passive investors don’t try to pick stocks, times, managers, or styles. Instead, they buy and hold diversified index based passively managed portfolios and enjoy risk adjusted market returns known as beta – β. The term “passive” translates into less trading of the fund’s portfolio, more favorable tax consequences, and lower fees and expenses than actively managed funds.
Major differences between two investment styles
Passive or Index investing aims to capture asset class or market returns.
It is dependent on market wisdom i.e. opinion of all the market participants put together.
Passive investors construct the based on pre-defined rules and processes. They seldom change the path.
Generally, passive or index investors are indifferent to market movements and thus are more calm and worry free.
Passive or index based products are generally available at lower cost.
Passive or index products are considered less risky as they eliminate human biases. They are truly subject to only market or asset class risk.
Active investing aims to generate additional returns over asset class or market returns.
It highly depend on opinion of a fund managers and their ability to consistently predict future.
Active investors tries to construct portfolios based on own research and has freedom to change the course anytime they want.
Active investors are highly reactive to market movements or news, information etc.
Active products are generally available at higher cost.
Active investment strategies are generally prone to high individual biases which give rise to overall risk.
Challenges of active investing
Basic premise of active investing is to beat the benchmark and generate additional returns. Such α generation is highly dependent on following challenges. Let us broadly see, what are these challenges and why generating alpha on consistent basis is difficult.
Difficult to predict future
Performance depend on how efficiently and consistently future is predicted.
To generate the alpha, it is very essential to accurately predict the future. Future of a company, its competitors, its regulatory framework and its future price on stock market and most importantly, how others will react to such predictions. Superior returns are directly proportional to efficiency of predicting future prices.
There are various methods of predicting the future prices. Some of which are; analyzing past performance, fundamental analysis, technical analysis and few also look at astronomical charts. However, if there is any accurate model which can accurately predict the future, all the investors in this world would have been wealthy by now.
In 1965, MIT Professor of Economics Paul Samuelson published a paper, "Proof that Properly Anticipated Prices Fluctuate Randomly,". His findings can be summarized as;
1) market prices are the best estimates of value,
2) price changes follow random patterns and
3) future news and stock prices are unpredictable.
There are many other numerous research papers available on how much it is difficult to predict the future prices.
Why index or passive Investing
Systematic risk i.e. risk which can not be controlled or eliminated.
E.g. Market wise risk, War, Recession, Political risk etc.
In finance, investment refers to acquisition of any financial product with an intention to either generate income by way of interest / dividend or to generate favorable returns by way of appreciation.
Return is the function of risk. More risks more returns and vice-versa.
But does that mean if a great batsmen play without a helmet, it will help in scoring a century? No. Similarly, as an investor, we have to decide how much risk is appropriate to take and what risk premium we can expect by taking such risk.
Risks are of two types. Systematic Risk and unsystematic Risk.
Systematic risk, also known as “market risk” is the uncertainty inherent to the entire market or entire market segment. War, recession, inflation, regulatory framework etc. are considered to be as systematic risks. Such risks are uncontrollable risks and no one can do anything about it.
Unsystematic risk, also known as “company specific risk” is the type of uncertainty that comes with the company or industry. Frauds, management change, product related issues etc. are considered to be as unsystematic risks. Such risks are controllable risks.
Generating return is not in investors’ hand, but controlling risk is. Index or passive investment helps investors in eliminating unsystematic risk and there by capturing the premium (returns) for taking systematic risks.
Unsystematic risk i.e. risk which can be controlled or eliminated.
E.g. Company specific risk, frauds, management issues, new competition etc.,
Advantages of index or passive investing
It is humanly not possible to beat the entire market on consistent basis. In such case, investors are better off with taking advantage of flowing with the market and not try to ride against the current. In essence, by adopting passive investment approach, investors are recruiting entire market to be their fund manager. Passive investment helps investors in
If one asks a large enough number of people to guess the number of green jelly beans in a jar, the averaged answer is likely to be very close to the correct number. Occasionally someone may guess closer to the true number. But as you repeat the experiment, the same person never is better every time – the crowd or a market is smarter than any individual.
Similarly, in (a jar of) stock market there are close to 4000 stocks (jelly beans). Whole market put together can take best estimate of next multibeggar stocks (green jelly beans) as compared to individual who try to forecast or predict the outcome. To repeat, the crowd or a market is smarter than any individual at predicting the future.
It may be counterintuitive. But groups of people are scientifically proven to be more intelligent than their smartest members in answering questions, problem-solving and even foretelling the future. The most famous example of this is the county fair game in which you guess a cow’s weight and win a prize for coming the closest. Guesses from all the players span a wide range by hundreds of pounds. But the average of all the guesses come very close the cow’s actual weight. This amazing phenomenon has been observed repeatedly in many experiments from county fairs to the stock market