Passive vs Active Management

Overview of Key Terms Index funds attempt to closely mirror performance of the total market or market sector with passive management. Actively managed funds attempt to outperform a market after accounting for expenses. Fund managers charge for their management, and in turn raise the gross expense ratio of the fund. Actively managed funds tend to have considerably higher expense ratios than passive index funds. We’ll break down why it matters. Active vs Passive Management Consider a higher expense ratio as compensation for a hedge fund, mutual fund, pension fund managers etc. professional savvy. We would assume fund managers who have spent years studying markets, would have an edge over the layman investor. In theory their expertise should allow opportunity to outperform standard market growth. Historical evidence have shown this simply isn’t true.

Market Tracking Funds and Horse Racing…?

A prevailing theory for stock market success is low-cost, passive index investing is the best bet over a time horizon of a lifetime. A metaphor used to envision this theory is one of a racetrack. A Day at the Races Allow me to draw the comparison of markets to a horse track. The physical tracks which the Belmont Stakes, Preakness, or Kentucky Derby are held. For the layman, betting on horses its more or less a crap shoot. One could study genetics, past performances, jockey reputation, or even simply judge how virulent the horse looked as it entered the stadium. But we are also blissfully ignorant of many factors influencing outcomes. A jockey may be using the race as a training run, adapting a new race style or a horse may be slightly injured etc. The point is the managers/stake-holders on the other side of the table have more information available.

The 8th Wonder of the World: Compound Interest

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein Key Terms Compound Interest: Interest calculated on the initial principal and on the accumulated interest from previous periods. Principal: The original amount invested or borrowed, separate from earnings or interest. Time-Value of Money: A core financial tenet inferring money available in the present is worth more than an equal amount in the future because of potential earnings over time. Essentially this means putting a $10,000 away today is worth more than putting away $10,000 in five years. The Time-Value of Compound Interest First we’ll examine simple interest or a scenario in which only the principal earns interest. Let’s say a bank exists offering 10% interest. For simplicity, let’s also imagine we invest $1,000 over 5 years.

Dollar-Cost Averaging Theory

Key Terms Dollar-Cost Averaging: Strategy of buying a fixed dollar amount for an investment on a consistent schedule, regardless of price. The strategy is meant to reduce the potential risk of market volatility. Equity: A stock or any other security representing ownership. The Constant Dollar Plan or Dollar-Cost Averaging Let’s make the assumption you, as an investor, are 100% sure what equity you would like to purchase. We’ll call it Stock A. Now you have two options. 1) A lump sum investment. Simply buying as much of the equity you can at once. You plan to invest $10,000 and do so with one large trade. 2) Buying the equity in portions over a set time-frame. An example would be deciding to buy $1,000 worth of Stock A each month, for ten consecutive months. In scenario two, you invest the same dollar value (total investment being $10,000) but spread the trades out over ten months. Over the ten month time span, Stock A’s price will likely change in value. Regardless of price fluctuations a $1,000 worth will be bought each month. Let’s say Stock A posts higher earnings than expected, therefore increases in value during month three. But by month five, the stock crashes due to unforeseen circumstances. During month three you will have bought less shares and during month five you will buy many more shares. Given this scenario let’s compare lump sum investing and dollar-cost averaging. For simplicity, Stock A only pays a single dividend a year and is not distributed during the time frame being examined.


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