It's hard to know which investment method to choose. Evidence shows that market timing doesn't consistently beat the market averages, especially after taxes and fees, and many have professed that passive investing is the path most investors should take. However, recent history suggests that passive investing isn't all that it's cracked up to be.
The Case Against Passivity
The value of the Dow Jones Industrial Average (DJIA), the S&P 500, and the Nasdaq were all higher 10 years ago. In fact, 10 years ago the Nasdaq was more than double what it is now. Of course, other time periods would be more kind, but the point is that over long periods of time, money dumped into index funds and left there doesn't have to generate a return. (For more info, check out How Now, Dow? What Moves The DJIA?)
The prime example is Japan and the Nikkei 225, which hit a high of 40,000 in 1990. That bubble popped and the exchange fell by half in the next 10 years, and is now at 10,000. So an investment in the Nikkei index in 1990 would only leave a quarter of that today, almost 20 years later. That evidence throws most investing strategies out the window, including passive index investing. So, if index funds are no sure thing, even over fairly long periods of time, should we consider trying to time the market?
Is Active Management Better?
It's important to be clear about the terms used here as they can mean different things to different people. Typically, active investors trying to time the market are associated with short-term profit making by monitoring their investments many times a day. Sometimes they use charts and other technical analysis, but regardless of their strategy, they are actively adjusting the portfolio to try to gain additional return. However, in this context, active management includes those that may not "day trade" in such a fashion, but try to select securities and adjust the portfolio to increase performance in less frantic ways. Actively managed mutual funds usually fall into this category. They may not trade daily, but they do actively adjust portfolios with the goal of higher returns. So, all active strategies here are contrasted with the clearly passive strategy of buying a broad index for long periods with no adjustment at all. (Learn more in Defining Active Trading.)
Overall, actively managed mutual funds haven't performed as well as the benchmark indexes they are supposed to beat. So using actively managed mutual funds still seems to be a questionable strategy. It could pay off, but selecting the winning mutual funds isn't any easier than selecting the underlying stocks, plus there are taxes and fees to deal with. However, if passive investing doesn't do well either, and doesn't have the upside potential of at least having a hope of beating the index, shouldn't active management be a serious consideration?
Which Strategy to Choose
If the evidence shows that both strategies can fail to provide the desired returns over long periods of time, how should you decide which strategy to choose? That answer depends on your need and desire for the potentially higher return of active management, as well as your ability to handle the higher risk. If you can frame the decision in terms of risk and reward, the choices will be more clear. Active management has the potential for higher gains than passive investing, but it also has the potential for higher losses. In general, it's more risky. If you don't take the risk with active management and invest in passive index funds, then your returns are limited to the benchmark minus the fees and expenses. However, your risks are also limited.
To view it in simple terms, if you want to take more risk in hopes of more reward, lean toward market timing and active management. If you are more risk adverse, and don't want to take more risk in hopes of higher returns, accept the returns from the index and lean toward passive index investing.
A Mix of Both?
Of course, there isn't any rule that says you can't do a little of both. For many investors, the solution that will give them the most psychological comfort, given the variability of future returns, is some potential for higher gains with some support for limited losses. While it's common to separate a portfolio into stocks, bonds and cash, one might also consider separating the stocks into passive and active. Have a portion of the portfolio that is trying provide excess returns and beat the market, while the passive allocation that just takes the index return. This may be especially helpful if neither method is a clear favorite.
When you decide which strategy is best for you, frame the question in terms of risk and reward. If you aren't clearly leaning one way or the other, don't make it an all or nothing decision. Allow yourself the option to choose some of both.
For more, check out our related articles: Words From The Wise On Active Management and 10 Tips For The Successful Long-Term Investor.