Back in 2013, I didn’t really like my job at the Pentagon and was looking to do something else that would be more fulfilling. Personal Finance has always been important to me, and I was good at allocating my 401k, so I started researching what it would take to become a financial advisor.
I still had my GI bill, so I decided to quit my job and go back to school to get a degree in Economics. This path would take me a year to do since I already had a bachelor’s degree in Public Health, and I wouldn’t have to get student loans, so it made the decision easy to do. I also decided to do a CFP certificate course from George Mason University to help me prepare for my new career.
Then six months before I graduated with my economics degree, I started looking at different financial advising companies that I could work for. Like anyone, I did an internet search for financial advising jobs, and I came across the nationally known companies that were all the same. They have their proprietary financial products they sell, some companies focused more on insurance than others, and it was up to the individual to build their book of business. I ended up choosing to work at this broker-dealer that was also a registered investment advisory firm because it seemed like the best fit at the time.
A broker-dealer is responsible for selling financial products and must follow the suitability rule. If a financial product is to be sold, it just has to be suitable and doesn’t have to be the best fit for the client.
In comparison, an RIA operates under the fiduciary rule, where they have to act in the client’s best interest. It’s a weird system for clients to interact with a financial advisor that is BD and RIA, since the hybrid advisor can act as an RIA while giving advice but can operate as a BD when selling a financial product.
I think there is a lot of conflict of interest in this business model, and most people don’t understand the difference. In my MBA legal business class, I wrote a paper about the legal distinction between the two, and up until that point, I didn’t understand the difference.
Since I didn’t understand the industry, I ended up at the national company and just followed their process because that’s how I thought financial planning was done. We were only allowed to sell actively managed funds or professionally managed accounts because that would pay the financial advisor a commission or asset management fee for implementing that product.
A lot has changed with the Reg BI and the DOL rule, where more disclosures are required, but I feel like it just makes the industry more confusing. This is why I choose the fee-for-service model because a client pays me a fee based on the complexity of their planning needs, and I’m not influenced to sell certain products over another.
So now I’m on the other side and have gotten more education about my industry. I know the deal between passive and active funds. In life, there are many choices that we can choose from, and one path is not going to be the best for everyone. So the idea is that we need to know the deal before we accept the deal, and here is how you should think about the whole active vs. passive discussion.
In investing, it mainly comes down to two choices for investment securities, passive and active funds. A passive fund follows a specific index as its investment strategy. For example, an ETF that tracks the S&P 500 index will hold the 500 largest companies in the US and weight the portfolio by market value.
If Apple makes up 5% of the S&P 500, then someone with $100 in an S&P 500 ETF will have $5 worth of apple. The other 499 companies follow this process. Here are some more characteristics of passive funds.
- Fees are low because the investment strategy is passive
- No need to spend a lot of time researching performance
- The fund will not surpass the benchmark but will be very close to it
- Can’t avoid total market risks
- Not very customizable investment strategy
An active fund uses an investment strategy of actively buying and selling securities. If a funds manager believes that Apple will do very well, then instead of holding onto 5% of Apple, they might want to do 10% as the fund’s total value. Since there is more involvement by the fund managers, the fees are going to be higher. Here are some more characteristics of active funds
- Fees are higher than passive funds, which could include Front-Load or Back-Load fees, 12b-1 fees, and a high expense ratio
- very customizable investment strategy options
- It can be beneficial during down markets
- High turnover could cause a more significant tax consequence
If you know that 20% of active funds outperform passive funds, which investment strategy makes the most sense to do?
Well, we can do an expected value calculation to see the difference between the two approaches.
Assuming that a passive averages an 8% return, 80% of the active funds get a 7% return, and the other 20% get a 9% return. We can do the following math:
Do a weighted average calculation
7% * 80% = 5.6%
9% * 20% = 1.8%
Add the two groups together
1.8% + 5.6% = 7.4%
By investing in an active fund in this simple example, we can see that group is likely to get a 7.4% as a whole, but some people will do better than 7.4%, and some will do worse. You can do things to tilt the odds in your favor, but this requires research and tracking.
If someone were to invest $300/mo for 30 years and get a 7.4% return, they would have $396,232.45. If someone made the passive approach and got 8% at $300/mo for 30 years, the amount would be $447,107.83. Getting a 9% return would get someone $549,223.04 under the same conditions.
This is over 30 years, so someone has to spend time tracking and researching to see if the current fund is doing well to get an extra $102,115.21 and not make a drastic mistake. Or someone could invest an additional $68.52/mo ($368.52/mo overall) into their passive fund and get the same outcome as doing the active route with a lot more certainty.
If someone values their time at $20/hr and spends more than 3 hours a month reviewing their investment performance, they better make sure that time spent is worth it.
Some active funds are outstanding, but a majority are not, and it requires someone to know their stuff to make sure they picked a winner that gives them a return higher than the benchmark. Or you can save yourself time and choose the passive approach.
Another choice is to blend the two strategies, and this most likely makes sense for someone whose retirement account has a limited investment selection.
When it comes to passive investing, different returns can be generated by choosing which sectors and segments of the economy you want your portfolio to be allocated in, like US stocks vs. developed international stocks.
I like expected value calculation because it can tell you how risky an option is. When it comes to lotteries, the expected value is always negative. For example, if you bet $1 to buy one ticket out of 1000, where the prize is $500, the expected value calculation would be:
x: -$1 – the cost
P(x): 999/1000 – number of losers
x*P(x): -999/1000 – value of losers
$499 – the potential profit
1/1000 – the odds of winning
499/1000 – the value of winning
Expected Value = -999/1000 * 499/1000 = -500/1000 = -$0.50
So the expected value is -$0.50 in this case. If someone buys a lottery ticket, they primarily use the dollar to fantasize about what they would do with the money rather than actually receiving it because the odds of winning are terrible.
This same concept can be applied to other areas of our lives, like your career and which jobs you take. There is the chance that you do earn the big prize, but make sure that you’re rational about the decision and not letting the big prize cloud your judgment that it is more likely to happen than it really does.
There are also ways to tilt the odds in your favor, but that requires increasing your knowledge about the subject, learning about the players in the field, and your skills. If doing these things are worth it, make sure it is based on a well-thought-out decision process so you can increase the odds of winning.
This will also prevent you from being the sucker in the room. And if you don’t know who the sucker is, then you’re the sucker, but doing an expected value calculation can help you see which path you’re taking.
If you have a 401k and are unsure what to look for between your passive and active funds, I just created a handout called five tips to help you understand your 401k. Claim it here to see which path you’re on.
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