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Strategy Two Arrows

Passive vs. Active Investing
by WealthEffect Staff

 
 

The path to long-term investing
 
  Passive investing is best for taxable accounts  
  Active investing is best for tax-exempt accounts  
 
1.

In deciding where to put your savings, you can choose between financial assets and real assets. In choosing among financial assets, you can allocate among stocks, bonds, cash, etc. With the money you allocate to stocks, you can decide to be a short-term trader or a high-risk speculator or a long-term investor.

If after all these choices, you prefer to focus on long-term investing in stocks, you might still wonder how often you should make changes to your stock portfolio — whether to be a passive or an active investor.

 
 
2.

Investors who have to pay taxes on their gains, or those who do not want to focus on their investments through the year, should consider passive investing. Once a year, during the New Year's holiday period, they can review and update their stock portfolios, and then leave them alone for the next twelve months.

Just prior to the end of the year, investors can decide which stocks to keep, which to buy and which to sell. Those on the sell list which have declined below their purchase prices should be sold before year-end; those which have capital gains should be sold at the beginning of the new year. Therefore, taxable losses will be incurred in the current year, reducing the tax bill, and gains will be recognized in the new year, with taxes deferred for fifteen months (the following April 15).

 
 
3.

For investments in a tax-exempt account such as an IRA or 401k, tax considerations are irrelevant. The passive approach might still be preferable, however, for investors who just don't want to spend the time and energy fine-tuning their portfolios through the year, or who question the wisdom of making more than few changes a year (Warren Buffett has argued that individuals would be better off if they were only allowed to make 20 transactions during an entire lifetime!).

The active approach should improve results for those who have a good understanding of valuation and a great willingness to fight conventional wisdom (or who have access to advice they trust on both counts). It's for those who are justifiably confident in their abilities both to analyze stocks and to endure the loneliness of the outsider (by definition, a contrarian will be outside the mainstream more often than not — an anxious situation for most people).

 
 


Suggestion: Go to Stocks in Depth or skip to W.E. Portfolios.

You can also access our current WealthEffect Portfolio (at the bottom of each portfolio is a link to that portfolio at year-end 1999).