Welcome back. So far in the series we have decided to invest in the stock market and we have decided on our asset allocation. Next, we must decide who will manage the portfolio. If you are new here, I recommend starting from the beginning.
ACTIVELY MANAGED OR SELF- MANAGED FUNDS?
If we are picking individual stocks then we must decide whether to pick our own stocks or have an investment manager/adviser pick them on our behalf.
A self-managed portfolio has the benefit of allowing flexibility, in the sense that we get to choose every company we invest in. We also have significant cost savings, due to not having to pay for expertise. We will still have trading (brokerage) costs though for buying and selling. A 0.5% difference in costs though can save 6 figures over our lifetime. The final benefit is that we have our best interests in mind with no conflicts of interest.
The downsides of a self-managed portfolio are that we must have a lot of time on our hands. It takes a lot of time to study companies, read their financial statements and board reports, and analyse the market conditions. Not only do we need plenty of time, we must also have basic knowledge of the finance industry and economics. It is also easier to get emotionally invested, instead of being rational. Part six in the series explains the impact emotions can have on our results. Finally, it is harder to be well diversified because we can't get access to as many companies as we could if we were in a managed fund.
A managed portfolio is advantageous in the sense that it frees up a lot of time. Returns from managed funds, according to research, are greater than that of individual investors (even after costs are considered). Managed funds also allow us to invest in companies that we may not have been able to on our own. This is because managed funds pool our money with other investors to form one large investment fund. This allows our money to go towards multiple large companies that require minimum levels of investments. In other words, we can be much more diversified. We also need less money to get started. Finally, it takes the emotions out of investing. We are allowing someone else to manage our stocks, so we are less likely to make spur of the moment, emotional decisions.
There are also a few downsides. The cost being number one. Fees may not sound a lot on paper but over time they are a silent killer, which we will discuss in part 13. It costs more to have someone manage our fund so ideally, we would expect a higher return from a managed fund than we would from a self-managed portfolio. We also lose a bit of control and flexibility. If we have a favourite stock and our fund manager decides to sell it, there is not much we can do.
If we can keep our emotions separate, don’t mind extra risk and have time and knowledge on our side, then it may be worth self-managing our portfolio. If just one of those factors is missing, then we are better off having someone manage our investments for us. Yes, it may cost more, but we will generally get better returns and have more diversification, reducing your risk.
There is a third option, index funds, which has been borne out of the need for low cost, diversified investing.
INDEX FUNDS (NO/MINIMAL MANAGEMENT)
Index funds are mutual funds, except they are not actively managed. They are passively managed. They are designed to track the returns of a market index. They are not trying to beat the market. They are the market. Because these funds are not picking and choosing individual companies, timing the market, buying and selling, the management fees are very low. It also means it couldn't be easier as an investor. Very little of our time required. Just sit back and watch it (hopefully) grow.
The main downside to self-managed investments is lack of diversification. Investing in index funds fills this gap, while maintaining the low fees. It gives the best of both. Not only that, it rules out emotional buying and selling and trying to outguess the market.
Index funds make investing super easy for beginners. We don’t need to have thousands of dollars and we don’t need to spend any of our time researching and stock picking. Even if we know nothing about stocks or investing, we can know that index funds are the best way for a risk averse, novice to get ahead. In fact, index funds often perform better than "professional'' stock pickers.
SO, WE HAVE A CLEAR WINNER THEN?
Possibly. But just like all other personal finance matters, there is no one solution for all. Index funds are the solution for many, especially novices, but not everyone. Some people with higher risk tolerance and long term investing horizons may want to try and beat the market for the chance of better returns. In this case, mutual funds may still make up an important element of someone’s portfolio. Just realise that it is only a chance of beating the index. It carries much greater risk for only a chance of greater returns. Mutual funds do have the added benefit of being a bit more flexible than index funds. If the market is in free fall, mutual funds can make adjustments to more stable investments such as consumer staples or high dividend stocks. There are certain stocks that do better in recessions than others and mutual funds can take advantage of this. Index funds don’t have this flexibility – you have no choice but to sell or ride the wave. The problem for mutual fund managers though is trying to determine when the market is in recession - timing the market is no easy feat.
Not only can we diversify our investments, we can hedge our bets and diversify how we invest too. Some in index funds and some in actively managed funds.
Finding an actively managed fund that can consistently beat the market is difficult and no one can know this. There is a lot of guesswork. History doesn’t help either, because the better an adviser has done over the last 10 years, the higher the chance they will perform poorly over the next 10 years due to the law of averages.
The important thing is to do our own research into each option, and choose the one that best suits our situation. Don’t just research the numbers, but also the non-quantifiable information. For example, we need to be able to use an adviser that we can trust, if we go for an actively managed fund.
Having both passive and active managed funds can be a good hedge against risk by limiting the downside to your investments, whilst not having to spend high amounts on fees for all our investments.
Next time we will discuss the different market cycles and trying to time the market.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here
Share your thoughts in the comments. This can be a hot topic but what type of management do you prefer? Index, self or other?