by Roger P. Levin, DDS, MBA, and Michael C. Smith, CFP, MBA

A comparison of passive and active investment strategies

Dr Bruce Davidson* is a 45-year-old orthodontist with two offices in a major metropolitan area. He has increased his production significantly in the past 18 months with the help of a referral-based marketing program. He has seen his production rise from slightly under $1 million in 2003 to a projected $1.6 million for 2005. The rising revenues have been used to pay down debt, fully fund a profit-sharing and 401(k) plan, and invest outside of the retirement plan. Prior to this increase in revenue, Dr Davidson had been unable to save significant amounts of money toward retirement and had lost a considerable sum of money in the tech crash of 2000. With the magic age of 50 only 5 years away, he has recently become concerned about his ability to retire at a time of his choosing rather than being forced to work longer than he would like.

As an orthodontist moves through his or her career from student to associate to successful practice owner, his or her income will rise—sometimes very quickly. Greater professional and personal success usually leads to a higher standard of living, increased expenses, and additional cash flow that can be invested for retirement. Many of you probably know friends and acquaintances who have lost significant sums of money in their investment accounts during the recent bear market. Devising an investment strategy that completely eliminates all risk of loss is virtually impossible unless all of your assets are held in cash, money markets, and US Treasuries. Since this ultraconservative approach is probably not the path you would want to take with your investment portfolio, we will look at a few investment strategies that have been successful for physicians such as Dr Davidson.

Passive Investing

A common trend in investing today is index investing. Rather than owning individual stocks and bonds, investors will buy low-cost mutual funds that mirror a particular index. The most well-known are the Standard & Poor (S&P) 500 index funds and funds that mirror the overall bond market. This style of investing is referred to as passive investing. Proponents of passive investing cite the low costs involved and the simplicity with which investors can purchase specific funds as significant benefits. The argument is that every dollar saved in management and brokerage fees remains invested and working for you—not working to enrich the executives of brokerage firms. Low-cost investing is what drives the passive investor. Another argument in favor of passive investing is that mutual fund managers attempt to beat the index that most correlates to their style of management, and it is rare to find a manager who beats the index on a consistent basis. If it is difficult to beat the index consistently, why not just buy the index? These are compelling arguments, and more investors are choosing this path. The Vanguard family of funds is at the forefront of this movement.

Why doesn’t everyone pursue this path? Opponents of passive investing point out that even the small management fee taken by the mutual fund company or ETF (exchange-traded fund) means that you will always underperform the index—if just slightly. Also, this type of investing fosters a do-it-yourself approach that led many investors to have far too great a percentage of their assets in technology funds in 2000.

Active Investing

Do passive investors receive solid advice about the appropriate percentage of assets that should be allocated to large-cap stocks versus emerging-market stocks? How are bonds considered in the portfolio? Many passive investors tend to be far too dependent upon the S&P 500 index—to the point of excluding many other asset classes—when working without the advice of a financial professional. They also tend to have portfolios that are far too aggressive for their long-term goals. Proponents of active investment management, typically those being compensated for the management of your investments, will point to the important role of advice and the ability to produce superior returns—but more importantly, limit losses in a poor market—as primary reasons for pursuing active management.

Dr Davidson, while quite knowledgeable about the investment markets, has decided that passive investing is an inappropriate strategy for this stage in his career. As he moves toward retirement, he wants to rely on the advice of a professional that he trusts—much like his referring dentists trust him to make the appropriate case presentation to their patients. After consulting a Certified Financial Planner, he has chosen to follow a disciplined approach to portfolio diversification.

Targeted Asset Allocation

Given that no one can predict with reasonable certainty which asset classes (stocks versus bonds, US versus foreign, large company versus small company) will perform the best over the next several years, many advisers have adopted the philosophy of diversifying portfolios across many asset classes. This is the theory that earned a Nobel Prize for Professors William Sharpe and Harry Markowitz for their modern portfolio and asset-allocation work. The rates of return on many asset classes are not correlated with one another (in the investment world, this is a good thing), and this leads to “multiple-asset-class” portfolios created to produce a targeted rate of return with less risk than a portfolio that includes fewer asset classes.

Dr Davidson’s financial planner determined the type of portfolio that is most appropriate, given the return the orthodontist needs to reach his long-term financial goals. This was accomplished through the preparation of a comprehensive financial plan that included a detailed analysis of his retirement-planning goals. The return goal was then used, along with a risk profile, to select an appropriate asset-allocation strategy. The portfolio recommended to Dr Davidson was the following:

Large Cap Growth 10%

Large Cap Value 14%

Mid Cap Growth 5%

Mid Cap Value 6%

Small Cap  Value 4%

Small Cap Growth 5%

International Value 6%

International Growth 5%

Emerging Markets Equity 5%

Municipal Bonds 8%

Intermediate Fixed Income 5%

Long Fixed Income 5%

High Yield 7%

International  Fixed Income 5%

Cash/Money Market 10%

Using the targeted asset-allocation strategy, Dr Davidson’s financial planner researched the appropriate investments (usually mutual funds or separately managed accounts) to be used for each individual asset class. As an example, we will use large-cap growth, with a target of 10%. The target of 10% for large-cap growth is given an allowable drift range, such as ±4%. This creates a band of 6%–14% of the portfolio that is targeted for large-cap growth assets. This range, along with all of the other asset classes and their ranges, is committed to an Investment Policy Statement. This Investment Policy Statement becomes the guiding force of the investment strategy, and it outlines the steps an investor is willing to take to achieve the desired rate of return.

Sophisticated software programs monitor portfolios and can notify the investment manager when a portfolio moves out of an acceptable range. For instance, the large-cap growth allocation could move to 15% (above the top end of the band), and municipal bonds may at the same time move below the lower threshold. (The total of the percentages must equal 100, so when one percentage increases, others decrease.) The portfolio manager would then rebalance the portfolio to bring the large-cap percentage back into the allowable range, while adding to the municipal bond allocation.

Targeted asset allocation and the Investment Policy Statement—if adhered to—will ensure that Dr Davidson always has a portfolio that is consistent with his goals. This strategy serves to remove any emotional approach to investing. The worst investment decisions many investors have made usually involve one constant factor: emotion. Investors make their biggest mistakes when logic and reason are outvoted by either emotion or greed.

The downside of targeted asset allocation is that the portfolio will rarely experience explosive growth. As a particular asset class is skyrocketing (think small-cap technology stocks circa 1999), that asset class will exceed its target percentage and be reduced. It may grow again and again, only to be pared back each time. This does not allow for the explosive growth one can see in other portfolio constructions. So if your primary goal is aggressive growth, this is not a strategy for you. If you are concerned about limiting your losses in a down market, as Dr Davidson was, this process can bring a focus and discipline that should help mitigate losses.

Deciding What to Do

There were many portfolio strategies available to Dr Davidson, and he has chosen to use the targeted asset-allocation approach, combined with the structure of an Investment Policy Statement. Two questions that he had to ask himself to make this decision were, “Do I prefer to do it myself, or do I want to have the help of a financial professional?” and, “Is achieving the highest return possible important, or do I want more of a disciplined approach that, in theory, removes the extreme highs and lows?”

Answering these questions yourself will help you decide on the right type of strategy for your investment portfolio—just as they helped Dr Davidson. z

Roger P. Levin, DDS, MBA, is the founder and CEO of Levin Group. A consultant for more than 20 years, he has published more than 2,700 articles and 49 books, and addresses more than 22,000 dentists each year. He can be reached at (888) 973-0000 or [email protected].

Michael C. Smith, CFP, MBA, is vice president of Levin Financial Services Inc. He can be reached via email at [email protected].

This article does not constitute legal or tax advice, nor is it intended to provide specific investment advice. Consult your legal, tax, and financial advisers if you have questions.

*The orthodontist’s name and some identifying details have been changed to protect the orthodontists’sprivacy.