By Ted Schwartz, CFP®

The biggest shift (and debate) during my decades in this business is the move from active management to passive. Active management means that your investment has a portfolio manager who is tasked with picking your investment from the universe of choices. His job, obviously, is to be above average in his choosing so that you do better than average in the returns you receive versus the risk that you take. A passive investment merely tries to duplicate an index of investments with no decisions made by a manager. The idea here is to do average with as little expense as possible incurred.

The battle over which of these ideas is superior has raged for more than a decade with both sides presenting evidence that they have the superior position. Both sides have logical arguments to make, but…the field has been tilting towards the passive side. Investors have voted with their feet, leaving actively managed mutual funds for Vanguard low cost index funds and ETFs (exchange traded funds). My belief after watching this for twenty years is… in a good market (where the trend is clearly up), you are probably better off in low cost index investments that capture average returns. The data shows that relatively few active managers outperform in these markets and also shows that these instances of outperformance tend not to persist (i.e. this year’s winning fund is unlikely to be next year’s winner).

So, does that mean we should all only own passive investments with a buy and hold for the long term discipline? I think the answer to this is….use some common sense! Remember, passive investments include zero risk management and you will always capture an average share of all losses in market declines. Let’s say you owned a passive investment in the Nasdaq index in early 2000. Stock prices were well over ten times their normal valuations, but there were lots of pundits explaining that this was a “new paradigm”. Passive investors were set to lose 78% of their principal by sticking to their long term buy and hold strategy. The Nasdaq index was at 5048 in March of 2000 and is at 5058 as I write this in July of 2016. An optimist might say “see, I told you to just hold onto it and it would come back”. A realist would say that, including 16 years of inflation, you are nowhere near having the buying power you had in 2000 when you made this ill-advised investment.

Common sense would tell you that when stocks are selling for over ten times their normal valuations, you should own less of them than normal. The expected future return on investing in those stocks was at an all-time low due to their being so overpriced. To manage your future risk and returns, any rational person should have been thinking that they needed to actively manage their allocation to this passive index. This is common sense. Failing to use common sense in investing can be very costly.

One piece of good news is that we now have thousands of passive indices to invest in and some have been designed to control your risk better than the older indices. These are often referred to as “smart beta” products, a term that annoys me as much as fingernails running across a blackboard. That said, they tend to reduce your exposure to investments that have gone up the most (think overpriced) and therefore are worth considering as you allocate your money. They do not replace common sense! It is the investor’s job to manage risk and return by deciding how to allocate money in a portfolio. Diversification is definitely step one. You want to own assets which have low correlation to one and another, so you don’t end up with all your eggs in one basket. Second, it is an investor’s job to buy the eggs that are on sale and sell a few of the eggs that are overpriced.

Unfortunately, this process is neither simple nor always immediately pleasant. An investor who decided that technology stocks were way overpriced in early 1999 and sold some of his tech stocks would likely be kicking himself by the end of the year. Almost all of the returns that year came from tech stocks. The rest of the market languished all year and posted disappointing returns. In hindsight, that investor would have saved themselves a great deal of capital in the long run by sticking to the simple discipline of using their common sense. Market returns do not reflect common sense in the short term, but the long term payoff can be tremendous.

Our common sense answer is that a good portfolio… actively managed and makes use of as many low cost, passive investments as possible. The old adage that most return come from asset allocation decisions seems to be right on. However, the world is not static and your portfolio requires attention as the world turns.