3.7 Active versus Passive Investor

Once you've determined the asset allocation that is best for you, you have to implement it via the investments you choose for your portfolio. At this point, the most important question you have to answer is whether you are going to take an active or a passive approach to investing. In a nutshell, the active investor believes that he or she can regularly generate (or choose fund managers who can generate) returns that are above the returns generated by some benchmark portfolio. In contrast, the passive (or index) investor wants only to match those benchmark returns at the lowest possible cost. Of course the skeptical reader can already see the potential for "gaming the system" here, via one's choice of a benchmark.

Arguments can be made for both active and passive investing but a much larger percentage of institutional investors choose to invest passively than do individual investors. The arguments for passive investing include

• reduced costs,
• tax efficiency, and
• the fact that historically, passive funds outperform a majority of active funds.

The arguments for active investing are

• that there are anomalies in securities markets that can be exploited to outperform passive investments and
• the fact that many investors and managers have outperformed passive investing for long periods of time.