There are two basic approaches to investment management:
  1. Active asset management is based on a belief that a specific style of management or analysis can produce returns that beat the market.

    • The active approach seeks to take advantage of inefficiencies in the market and is typically accompanied by higher-than-average costs (for analysts and managers who must spend time to seek out these inefficiencies).

    • Market timing is an extreme example of active asset management. It is based on the belief that it's possible to anticipate the movement of markets based on factors such as economic conditions, interest rate trends or technical indicators. Many investors, particularly academics, believe it is impossible to correctly time the market on a consistent basis.

  2. Passive asset management is based on the belief that:
    • Markets are efficient.
    • Market returns cannot be surpassed regularly over time.
    • Low-cost investments held for the long-term will provide the best returns.
Stock Selection
For those who favor an active management approach,stock selection is typically based on one of two styles:
  • Top-down - managers who use this approach start by looking at the market as a whole, then determine which industries and sectors are likely to do well given the current economic cycle. Once these choices are made, they then select specific stocks based on which companies are likely to do best within a particular industry.

  • Bottom-up - this approach ignores market conditions and expected trends. Instead, companies are evaluated based on the strength of their financial statements, product pipeline or some other criteria. The idea is that strong companies are likely to do well no matter what market or economic conditions prevail.
Within the tutorial Guide to Stock-Picking Strategies we explore the art of stock picking, with the aim of achieving a rate of return that is greater than the market's overall average.

Passive management concepts to know include:
  • Efficient market theory - based on the idea that information that impacts the markets (such as changes to company management, Fed interest rate announcements, etc.) is instantly available and processed by all investors. As a result, this information is always taken into account in market prices. Those who believe in this theory believe that there is no way to consistently beat market averages.

  • Indexing - one way to take advantage of the efficient market theory is to use index funds (or create a portfolio that mimics a particular index). Since index funds tend to have lower-than-average transaction costs and expense ratios, they can provide an edge over actively managed funds, which tend to have higher costs.

Within the tutorial Index Investing, we discuss some of the major stock indexes and explain how one can invest in the stock market through index funds:

When choosing index funds, it's important to realize that not all index funds are created equal. Read more on this topic within the article You Can't Judge an Index Fund by It's Cover.

Consider these sample exam questions:
  1. The efficient market theory states that:
    1. Future market prices are determined by the discounted value of future dividends.
    2. Technical analysis tools cannot be used to beat the market, since current prices already reflect all available information about previous price patterns.
    3. Current market prices already reflect all available information.
    4. Market prices are determined by supply and demand.
The correct answer is "c"; "b" is incorrect, since the efficient market theory is not concerned with technical analysis.
  1. Passive asset management involves:
    1. Using index funds as the investments for each asset class
    2. Choosing the stocks or mutual funds to be purchased for each asset class
    3. Buying securities for each asset class and holding them until the funds are needed
    4. Buying securities for each asset class and selling them when they reach their price targets
The correct answer is "a" - while index funds are not a requirement of passive management, they are a frequently used tool. "c" is incorrect because passive management does not preclude making portfolio changes. For example, periodic rebalancing is performed, and changes can be made in response to changes in the client's risk tolerance, financial situation, goals and so forth.

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Frequently Asked Questions
  1. What Was the First Company to Issue Stock?

    The Dutch East India Co. held an IPO in 1602, making it the first company to issue stock.
  2. When Does a Corporation Decide to Refinance Debt?

    Favorable market conditions or the strengthening of a credit rating may lead to refinancing.
  3. What Is an Odd-Lot Buyback?

    Odd-lot buybacks involve lots of less than 100 shares. Learn how companies get these shares back.
  4. Can I buy a house directly from Fannie Mae (FNMA)?

    Yes, Fannie Mae does sell properties it's foreclosed on; each property is sold in "as is" condition.
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