When it comes to investing, there are several ways to build a portfolio. While new investment products and trends continue to emerge, most strategies still fall into one of three broad categories: Passive, Active, and Evidence-Based investing.
Understanding the differences can help investors make more informed decisions about how their money is managed and, ultimately, how likely they are to achieve their long-term financial goals.
Passive Investing
With passive investing, the philosophy is simple: rather than trying to identify tomorrow’s winning companies, investors buy a broad section of the market and capture its overall return.
For example, an investor seeking exposure to UK shares might invest in a fund that tracks the FTSE All-Share Index, which represents hundreds of listed UK companies. Instead of attempting to predict which companies will outperform, passive investors accept that markets are highly competitive and that today’s share prices already reflect vast amounts of publicly available information.
Supporters of passive investing argue that consistently outperforming the market is extremely difficult, particularly after costs and taxes are taken into account. As a result, passive funds are often designed to keep costs low, as there is little need for costly research teams or frequent trading.
Over the past two decades, passive investing has grown significantly in popularity as investors have increasingly focused on the importance of diversification, cost control and long-term discipline.
Active Investing
Active investing takes the opposite approach.
Rather than owning the entire market, active fund managers attempt to identify companies, sectors or themes they believe will outperform in the future. A UK active fund, for example, might hold around 50-100 carefully selected companies from the wider market.
The goal is straightforward: achieve returns that are better than the market average.
Of course, if a manager chooses a smaller number of investments than the market as a whole, their returns will inevitably differ from the market’s performance, sometimes positively and sometimes negatively.
While there are undoubtedly talented fund managers, the challenge lies in identifying who will outperform in advance and whether they can continue to do so consistently. Research from S&P Dow Jones Indices’ SPIVA Scorecards continues to show that the majority of actively managed funds fail to outperform their benchmark indices over longer periods, particularly after fees are taken into account. Furthermore, the relatively small number of managers who do outperform in one period often struggle to repeat that success consistently.
Because active management relies heavily on research, analysis and trading, costs are often higher than those associated with passive investing.
Evidence-Based Investing
Evidence-Based investing sits somewhere between passive and active management.
Like passive investing, the starting point is broad diversification and the belief that trying to consistently outguess the market is unlikely to be a successful long-term strategy.
However, evidence-based investing goes a step further by incorporating decades of academic research into how markets behave.
Researchers, including Nobel Prize-winning economists, have identified certain characteristics, known as factors, that have historically been associated with higher expected returns over the long term. These include:
- Smaller companies (Size)
- Lower-priced or “value” companies (Value)
- More profitable companies (Profitability)
An evidence-based portfolio doesn’t attempt to predict which specific companies will outperform. Instead, it systematically increases exposure to areas of the market that research suggests have delivered higher returns over long periods.
For example, rather than choosing a handful of small companies that a fund manager believes will succeed, an evidence-based strategy may invest in thousands of companies globally while allocating a slightly greater proportion to smaller businesses.
This rules-based approach aims to capture long-term sources of return without relying on market forecasts, stock picking or attempting to time market movements.
Why We Favour Evidence-Based Investing
At Blackdown Financial, we remain proud advocates of the Evidence-Based approach.
As independent advisers, we have spent many years reviewing different investment philosophies, academic research and real-world outcomes. Our conclusion remains unchanged: investors are generally best served by focusing on the factors they can control, such as diversification, costs, tax efficiency, behaviour and maintaining a long-term perspective.
Evidence-Based investing combines many of the strengths of passive investing with insights gained from decades of financial research. It avoids the need to make speculative predictions about which shares, sectors or countries will outperform next while still seeking to improve expected outcomes through a disciplined and systematic process.
Most importantly, investing should never be about trying to “beat” somebody else. It should be about helping you achieve your personal goals, whether that’s retiring comfortably, supporting your family, travelling more, leaving a legacy, or simply enjoying peace of mind knowing your finances are working towards the life you want to live.
As David Booth, Founder and Chairman of Dimensional Fund Advisors, famously said:
“The number of managers that can successfully pick stocks are fewer than you’d expect by chance. So, why even play that game? You don’t need to.”
Ultimately, successful investing is rarely about finding the next big winner. More often, it’s about following a sensible, evidence-based strategy, staying invested through market ups and downs, and allowing time and compounding to do the heavy lifting.
Warm wishes,
Simon
Simon Cutler DipFA, MIFS, Certs CII (MP&ER)
This article represents the opinion of W&T Ltd trading as Blackdown Financial only and is intended as information only. The content of this article should not be construed as advice or recommendation.