Saturday, January 26, 2008

Active or Passive Investment?

Although I am just getting my feet wet in the ocean of saving and investing, I have been spending and plan to continue to devote much of my spare time to learning about all aspects of finance. I am currently laying the groundwork for future endeavors, but one issue that I've seen crop up a few times in my reading is active vs. passive investment management. I came across this excellent article in San Francisco magazine, by way of the invaluable Get Rich Slowly, describing the value of the index fund over traditional stock picking and managed mutual funds.

As I understand it (an admittedly rudimentary understanding), active stock management is when one invests in individual stocks and monitors the market daily, anticipating the optimal times to buy and sell stock for maximum returns. This active management also manifests itself in the form of mutual fund managers who observe the market on behalf of their clients - taking significant fees to do so. Everyone from stock brokers to financial advisors to investment house managers profits extraordinarily from this system.

However, the relatively recent (as of the early '70s) rise of the index fund is a direct assault on the classic system of stock investing. Index funds basically take a stock index like the Dow Jones or Standard and Poor's (S&P) 500 and buy stocks in the proportions in which they exist in that index, assuming that, for the most part, a given stock price is an accurate reflection of the value of a company. The fund follows the ebb and flow of the entire market, and rather than trying to select individual stocks to beat this natural expansion and contraction, it relies upon historical precedence that the stock market generally rises in value over time. This method is very passive - so much so that it can be managed by computer for a tiny fee, rather than a team of exorbitantly-paid financial services people. And with very rare exceptions, mutual funds do not outperform index funds. Considering the fees and expenses involved with some of these high-performing mutual funds, index funds seem like a wise investment indeed.

Read the entire article, it's fascinating.

Also, a great post at The Simple Dollar explaining how index funds work.

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