After you’ve saved up some money and decided that it’s time to start investing, the question becomes how should I invest?
There are basically two ways to go: active investing or passive investing.
Active investing is buying specific investments in order to maximize return and minimize risk. Passive investing is buying an index fund or Exchange Traded Fund (ETF) that tracks the performance of some underlying securities.
The most popular index fund or ETF tracks the S&P 500. The S&P 500 is a grouping of the 500 largest companies in the United States by market capitalization. Market capitalization equals the number of common shares outstanding in a company times the price per share.
Getting back to the original question, how should one invest (actively or passively)? The answer is: “It depends.”
Warren Buffett, the Chairman and CEO of Berkshire Hathaway, provided the answer to this question. Mr. Buffett had this to say:
Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: “Too much of a good thing can be wonderful.”
Warren E. Buffett, 1993 Chairman’s Letter to Berkshire Hathaway Shareholders
There’s a lot of wisdom in this quote. If you’re a person who knows how to value businesses and assets, it makes no sense for you to diversify widely by buying an index fund or ETF. You’re much better off spending your time analyzing companies and buying the most undervalued securities you can find. This will lead to much higher returns and a reduction of risk in your portfolio.
However, if you’re a know-nothing investor, meaning you don’t know much about business or valuation, you should seek to diversify widely. A great solution for this is to buy a low-cost index fund or ETF that tracks the S&P 500.
Now, it’s very important that you make a rational assessment of the type of investor you are: know-something or know-nothing. It can be financially devastating for you to think and act like a know-something investor, when in fact you are a know-nothing investor.
It is much easier to lose money in active investing. You are exposed to company and security-specific risks, and your portfolio could also turn out to be too concentrated in a few investments or economic outcomes.
The decision between active and passive investing doesn’t have to be binary, though. In my mind, there’s a spectrum. You can do a little active investing while you’re investing the majority of your funds in a passive manner. This can be a good way to learn how to actively invest and potentially garner higher returns in the future.
If you are new to investing, however, I highly recommend that you start slow and invest passively (i.e., index). And then as you gain more knowledge and experience, you can start dipping your toe into the active investment pool. This phased approach should result in a decent investment return with minimal risk to start, and provide you with opportunities to learn how to actively invest, so that one day you could possibly hit a few investing home runs and achieve finance freedom early in life. That seems like a pretty good risk/reward trade-off to me.