Financial independence is achieved through low spending and high saving. Indeed the two concepts are expressly linked. After spending is under control, the next step is figuring out how to save. 

Sorting the innumerable investment options can be overwhelming. With everything from stocks, to real estate, and even crypto currencies (please don’t invest in crypto currencies), an investor today has many options on where to park his wealth. Today the focus will be on the stock market and sustainable equity investing.

Before making a new investment, three components should be top mind. 

• Fees/expense ratio: Every investment will have some cost associated with owning it. The cost is paid to an individual or company that manages the asset. Understand the fee structure and evaluate the costs against the potential returns.
• Return: A prospectus highlights historical asset returns. Remember that past performance does not guarantee future gains. Take this information as one component of any larger decision.
• Tax implications: Understanding how the investment is managed will help with the tax implications. If the fund is actively managed (we’ll get into those specifics below), profit made on every trade is taxed at a 15-20% rate. A passive fund may never be traded, keeping tax implications in check until the investor is ready to sell. 

Based on the criteria above, one investment is better than all the others, the index mutual fund. An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500)

I’m going to write something that that might surprise you. Markets always go up. Not every month and not even every year, but over time the markets always rise. Always. 

As you can see from the chart above there are ups and downs in the market over time, but the trend is clear. The market has always risen.

If at some point markets stop rising, then you have more to worry about than your investments. So realistically you can plan for markets to rise in the future.

Buts lets take a step back and compare the two main methods for investing in the stock market: active and passive investing.  

Active investing

In active investing, a portfolio manager selects assets in an attempt to beat the overall market and the benchmark indexes underlying it. In theory, the manager is deeply researched and trades to take advantage of the short-term fluctuations in the market. If returns are higher than the benchmark indexes, the portfolio manager has increased risk in exchange for a return higher than the market.  

In theory, an active investor leverages a deep knowledge in a company or industry to select individual equities that perform better than the market as a whole. The challenge of choosing individual equities is that it limits diversification, a risk management theory that holding a divers set of assets will over the long term yield more productive growth while minimizing downside risk.

Is possible to achieve better returns than the market? Sure! Warren Buffet did it. Since founding Berkshire Hathaway in 1952, Buffett has returned 155 times the S&P 500.  Over that time period, a $10,000 investment in a low-cost S&P 500 index fund would have grown to about $1.28 million. Pretty impressive, until you consider that a $10,000 investment in Berkshire Hathaway would have grown to more than $197 million over the same time period — about 155 times as much as the S&P investment.

For every story about an investor that beat the market, there are hundreds of thousands unwritten ones about the people who do not. Over a 15 year period, less than 5 percent of active investors can beat the market. Lets take a look at the data from S&P’s Spindices.  

In other words, over the last 15 years from 2003 to 2018, only one in 12 large-cap managers, one in 14 mid-cap managers, and one in 24 small-cap managers outperformed their benchmark index. It is possible for some active fund managers to “beat the market” over various time horizons, though there’s no guarantee that they will continue to do so in the future. 

Lets take a very high level look at the pros and cons of active investment.

Pros:

• Big upside: Active managers need not follow the general market trends and can choose equities with potential major upsides. Picking a stock that launches into the stratosphere can offer enormous returns for an investor.
• Hedging: Active managers can hedge investments with various techniques such as short sales or put options. They can also sell specific stocks or those associated with industries when risks become too big. Passive investors are stuck in the indexes they hold. 

Cons:

• High cost: The expense ratio for actively managed funds is very high. The average is 1.1 percent.  Not only does the active manager need to beat the market, he has to do at least 1.2 percent better than the market to offer the investor a superior return. Additionally, no matter how much the investment rises or falls, the fund manager collects the expense ratio every year. 
• Tax implications: Active investing is predicated on the idea of buying and selling equities to take advantage of volatility in the market. Profit made on every sale is taxed at a 15-20 percent capital gains rate.
• Risk: The big upside mentioned above comes from the enormous risk taken by betting on those diamonds in the rough. As we’ve noted above, repeating that success over time is fighting historic trends. 

The impetus to choose an activist investment strategy is to beat the market. But investment fees immediately put the active investor at a disadvantage. If we consider the average manager expense ratio above, not only is an active manager competing against already difficult odds, he is starting at a disadvantage of 1 percent. 

As someone aspiring to financial independence, would you bet your future financial future on the same odds as one of the riskiest bets in roulette ? If so, I have a terrific ice delivery venture in Alaska to talk to you about.

Passive investing

Unlike active investing, passive investing does not intend to beat the market or its underlying indexes. Instead, passive investment managers mimic the returns of an index by purchasing all of the holdings in the index. Instead of spending time and effort researching individual equities, the passive manager matches the holdings and returns of a major index.

Because the manager is not trying to beat the market with fancy research, costs can be kept low, returning more to the investor. Its called a passive investment because you buy it and leave it be.

That is not to say management is free, but the expense ratio of the index fund is on average significantly lower than an actively managed fund. Vanguard, one of the most popular passive investment managers, has an average expense ratio of .11 percent. 

This means a passive investment manager can begin each year with a .99% head start on actively managed funds. That makes a hug difference over a 15 year period.

Lets take a look at the pros and cons of passive investing.

Pros:

• Low cost: The average expense ratio on a passive investment is around a tenth of a percent.
• Tax implications: Because the passive investment tracks an index the stocks are purchased once and sold only if the index is rebalanced.
• Transparency: There is never any question what equities are in the portfolio because the manager follows a publicly available index.

Cons:

• Modest returns: In exchange for low fees and stability, a passive investment generally never beats the market (which is the point). But this could potentially miss out on big upsides when some equities boom.
• Flexibility: Holding an index means there is limited scope to rebalance a portfolio without selling off the index.

The Google IPO

Lets conclude with an anecdote. Way back in 2004 in the lead up to Google’s IPO, one of the company’s vice president’s realized the company’s public listing would spawn hundreds of new millionaires. He was not the only person who noticed. Goldman Sachs, Marryl Lynch, J.P. Morgan bankers flocked to the campus to seek out new clients for their active investment businesses.

To ensure the future millionaires were well prepared to handle the onslaught of seasoned Wall Street investors, the company set-up a series of internal financial intelligence workshops led by Nobel Laureate and Stanford University thinker William Sharpe, Former dean of the Yale School of Management and Princeton economics professor Burton Malkiel, and Vanguard founder John Bogle.

What advice did these luminaries offer these soon to be rich tech workers? Active investing doesn’t work. Instead of paying high costs for elusive high returns, better instead to put their money in a low-cost, diversified index mutual fund and get on with the business of building a great company.

The lesson is one that can be applied to every individual. Passive investing is a stable, long term strategy for building wealth. Put your money in an index fund, forget about it, and go on with living your life.

Conclusion

Financial independence is not about getting rich quick. It is about taking very deliberate action over the long term to get rich slowly. Passive investing is the most sustainable method for building wealth over time.