I (Phi) am an active investor. Phi’s definition of a passive investor is someone who would invest his savings in proportion to the market capitalisation of the total investable universe. However, all savers, individuals or institutions, are forced to be active investors whether they like it or not.
Investors select from the investable universe based on their future expected liabilities, whether contractual or aspirational. These could include, as in my case, the wish to donate or bequeath part of their savings. The amount of risk that an investor is prepared to take depends, firstly, on the characteristics of his liability stream — future basic needs such as living or medical expenses are very different from a planned holiday or a donation. It depends, secondly, on the timing of his liabilities. Thirdly, it would depend on the investor’s inherent risk appetite which could either be a function of his genetic makeup or his education and past experiences. Finally, an investor’s tax situation would also influence his investment decision.
Therefore Phi and every other saver are forced to be active investors with regards to asset allocation. Asset allocation involves the selection of various subsets of asset classes from the investable universe. These asset classes can be defined in a variety of ways, but typically the legal properties of the instruments, including their maturity profiles, currencies and jurisdictions have naturally and unnaturally created asset classes. US large capitalisation equities or Euro money market instruments with a maturity of less than 12 months would be examples of asset classes.
Within asset classes, a passive or an active investment approach can be followed.
The passive investor aims to obtain the overall return of an asset class by investing in proportion to the market capitalisation of its various constituents. I (Phi) am an active investor because of my belief that one can out-perform the overall return of an asset class, say US large capitalisation equities, by investing in proportions that differ from the market capitalisation of the constituents. I will explain in further posts why I hold these beliefs. I will also identify possible investment opportunities across and within asset classes from time to time.
The passive investor follows his strategy because he believes that he does not have the skill to outperform the market and he does not have the skill to select somebody that can outperform the market on his behalf, after costs. Alternatively, the passive investor could believe that the skill to outperform the market does not exist and cannot be acquired. He believes the market is efficient in all senses and the current prices of assets reflect all the information that is available and is, therefore an accurate reflection of the correct value given the associated risks. Any unexpected change in an asset’s price is due to new information that appears randomly.