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So You Think You Can Trade? Active Vs. Passive Investing

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My first job out of school was working in compliance for an investment firm.  Compliance ensures a firm is meeting regulatory expectations (following the rules). It's an interesting position to be in, you need to be on top of everything. You work with nearly every department. Dealing with traders, research analysts, investment bankers, never a dull moment.

What amazed me working here was how much effort went into every investment decision. Teams of super-bright people (CFAs, MBAs, PhDs and the like) constantly analyzing companies, industries and the greater economy. Company visits, conference calls, mulling over financial statements, research reports, the 24/7 newsfeed, the work never stops.

This tremendous effort is not uncommon in the investment industry. It's the standard. It is a highly competitive environment. You might have a team of brilliant people equipped with the newest technology, but so does the firm down the street.

Having said all that, it is still very common for the average person to think they can pick stocks and compete with the pros. This is not sensible. You're at a massive disadvantage in terms of time, experience, manpower, information, technology, just to name a few. Your Robinhood account and tips from Reddit won't cut it.

Even most professionals fail to outperform the market. A 2016 study by S&P found that "over the 10-year investment horizon, 82.14 percent of large-cap managers, 87.61 percent of mid-cap managers, and 88.42 percent of small-cap managers failed to outperform (their index benchmarks) on a relative basis." Markets are just too unpredictable and competitive to win consistently.

Luckily there is alternative to stock picking, passive investing. Unlike active investing which involves research, analysis and frequent trading in hopes of outsmarting the market, passive investing is about being the market.

A major component of passive investing are exchange-traded funds (ETFs). ETFs allow you buy a large basket of individual stocks or bonds in a single fund in order to track an entire economic sector or index such as the S&P 500.

If done correctly, ETFs are a great way to build a portfolio that simply mirrors the overall market. Given that over 80% of professionals underperform market returns, achieving market returns (with significantly less effort) is a huge win!


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