How about them earnings?
(Active vs. passive investor)
January 22, 2021 by The Q.ai Team
The educational component of this newsletter focuses on active and passive investment strategies
What we all though WFH was like until we actually had to do it
This Week’s Biggest Headlines
- The Dow, Nasdaq and S&P hit record highs following the inauguration. The Dow rose to 31,188, Nasdaq 13,457 and the S&P 500 ended the day at 3,852. Read more.
- Netflix hit 200 million subscribers for the first time. The company ended the year with 204 million subscribers, adding 8.5 million between October and December. It’s also now cash flow positive, which is a big deal considering the company has had a negative cash flow since 2011. Read more.
- Microsoft and GM partner in autonomous vehicle project. It’s a good deal for Microsoft as it will become the primary cloud provider for Cruise, GM’s majority-owned autonomous car unit, and will speed the development of commercialized self-driving vehicles. Microsoft and Honda Motor are part of a group of institutional investors to have invested a combined $2 billion, driving the valuation of Cruise to $30 billion. Read more.
- Jack Ma makes rare appearance after going MIA. In a 50-second video, Alibaba CEO, and enemy #1 to some high-power government officials, attempts to settle mounting rumors surrounding his disappearance following his controversial speech in October that criticized China’s regulatory system. The government clapped back by suspending what would have been the largest IPO ever. By the way, investors are not as relieved as you would think. Many U.S. investors have in fact reduced their positions or sold them off altogether. Read more.
- American Airlines launches a wine company. Everything about this is strange, but if there’s one thing we know about the airline industry it’s that they’re struggling a lot. This is the time to branch out and look for alternative methods for keeping a business afloat. Read more.
- United Airlines and Delta aren’t doing too well either. United Airlines sank after the company shared that it is unable to predict when demand will rebound while Delta forecasted that it would break even on a cash flow basis in the second quarter. Read more.
Number of scheduled passengers boarded by the global airline industry
Have you ever wondered why earnings are such big market movers?
The stock market prices are not always reflective of performance but rather market expectations. When earnings are higher than expected, the stock usually goes up while missed expectations tend to result in the stock dropping. When a company misses its earnings, it might suggest that the company is not in great shape or there’s an underlying problem in the economy.
That’s why certain earnings can really have an effect on popular indexes like the S&P 500 and Dow, especially if they’re all from industries that have been hit by an economic hardship (such as the one we’re dealing with now).
Tesla’s strong third quarter earnings is a good example of earnings driving the price of the stock. It beat all expectations from analysts and also delivered a record 139,000 vehicles.
According to Refinitiv:
- Earnings per share (adjusted): 76 cents vs 57 cents
- Revenue: $8.77 billion vs $8.36 billion
- Net income (GAAP): $331 million vs $394 million
It was also its fifth straight quarter of profits.
Earnings will tell the full story about the company, but there are still certain things to read between the lines. For example, Tesla’s operating costs increased by 33% that quarter to $1.25 billion because it had opened new factories in Austin, TX and Germany. Musk also warned that it could take up to 2 years before these factories hit full capacity after beginning operations in 2021.
While understandable for investors to see high operating costs as a turn off, the company managing to remain profitable and the new factories leading to a high likelihood for growth – albeit not immediately – should be a tip off that the stock is worth hanging onto. Since deliveries are an important KPI tied directly to revenue, and Tesla has shown a 36% year over year increase in deliveries, it’s no wonder why so many investors bought Tesla stock last year, cementing its 695% surge.
The difference between a passive and active investor
There are several ways to categorize investors based on their investing style. The most common ones you’ll see are passive and active investors.
Passive investors follow “buy and hold” strategies to make small but steady gains over years or even decades. While this strategy comes at low cost and high tax efficiency, returns rarely outperform the market.
Active investors are after high rewards on both short- and long-term investments. Many active investors are day traders seeking above-market average returns. However, these investors are less likely to turn a huge profit in the long run due to the costs of frequent trading and actively managed portfolios.
Each investor is different. We have are own capital, risk tolerance and security preference, and no two people invest for exactly the same amount of time. As a result, some investors will take more risk, while others less; some investors will rely heavily on aggressive stocks, while others will only go for blue chip companies.
With so many options on the table, there is more than one way to categorize an investor. For instance, a broad definition allows for two types: retail investors (individuals) and institutional investors (organizations).
However, there are other ways to categorize investors under these umbrellas. While the names for these types may vary, at the end of the day, there are four main “types” of investment styles.
The distinction between an investor and a trader
Simply put, an investor is looking for long-term gains over the course of years or decades, while traders are after short-term profits.
A trader, on the other hand, is a little more complex. There are distinct types of traders, and several ways to categorize these distinctions. For instance, scalp traders and swing traders are named for how long they hold their investments – as little as seconds for scalp traders, while swing traders may sell within a few weeks.
Another common way to categorize a trader is by their specific investment strategy, most notably in the stock market.
Passive investors follow an investment strategy of “buy and hold” wherein they purchase securities or other products. Instead of selling their investments at the next opportunity, they hold onto them for years or even decades.
- Passive investors subscribe to the underlying assumption of passive investing, which states that the markets will always perform – eventually
- The goal of passive investors is to minimize the costs and risks of investing while maximizing returns
- Rather than trying to out-think the market, these investors select for a well-diversified portfolio (often composed of securities such as ETFs and mutual funds as well as individual stocks) that spreads risk as well as growth
- Passive investors typically ignore technical markers such as fundamentals in favor of the longer-term trends. While short-term gains of this strategy may be small, in the long run, this strategy can build great wealth.
Pros and cons of passive investment strategies
As we mentioned above, many passive investors turn to passively managed funds, such as ETFs or mutual funds, in order to invest their money into more stocks at once. These come with a few benefits compared to actively managed funds. Two of the biggest benefits include:
- Incredibly low expense ratios (costs). In a passively managed fund, the stocks are selected based on the underlying indices; no hands-on management required. Even if you don’t invest in a fund and choose the securities yourself, a passive strategy comes with lower costs due to trading less, which incurs less in brokerage and other fees.
- Tax efficiency. This ties into the low costs above. Because buy-and-hold strategies don’t return massive capital gains year to year, they can cost less in taxes (especially if you’re invested in a passive fund).
However, passive investing comes with one major downside: the returns year to year rarely beat the market. While some passive funds can outperform the market, this depends on the underlying performance of those indices or sectors.
In the case of investors who manage their own passive portfolios, they still may not see major returns, because passive investors frequently hold onto their securities even when the market takes a turn for the worse. In the long run, this can be a smart strategy; but in the short-term, this leads to smaller gains.
Active investors are in it for the big money. Whether they purchase shares in an actively managed fund or select their securities themselves, active investors have one goal in mind: to outperform the market’s average returns. They do this through a variety of strategies, but the overarching theme is taking advantage of short-term fluctuations as well as long-term trends
- Active investing is a time- and labor-intensive strategy that involves deep analysis of the market and each stock, bond, etc. within a portfolio
- In the case of investors who purchase into an actively managed fund, the portfolio manager oversees clusters of analysts who examine various financial metrics and available data
- Depending on the objectives of the fund, analysts may research a stock’s fundamentals, historical performance, project a future outlook – or take other measures such as using AI to examine all available data.
Where do day traders fit in?
For individual investors who prefer an active strategy, they have to do all of this work themselves. Therefore, many active investors turn to day trading. While not all active investors are day traders, all day traders are active investors by definition.
Day traders seek to buy and sell stocks for a profit as quickly as they can within their strategy. Some may choose to sell within seconds (scalp traders) for profits of pennies on the dollar. (Many computerized investors take this approach). Other traders buy and sell the same security with a few days or weeks between transactions (swing traders).
Pros and cons of active investment strategies
Whether you prefer to buy into an actively managed fun or actively manage your portfolio yourself, there are some commons pros and cons of active investment strategies.
The primary benefit of active investing is that this strategy, with the right technique and a little luck, can provide above average returns compared to the rest of the market. This can increase short-term gains drastically compared to a passive strategy.
However, studies have shown that many active strategies are only successful in the short term. Due to the high costs of an actively managed portfolio, as well as the higher costs of trading frequently, the strategy itself can be self-defeating and lead to less gains in the long-term than a passive strategy.
Furthermore, many active investors make calls on individual assets, which means that betting too much on the wrong security can lead to massive losses overnight.
The Bottom Line
These are not the only investment styles out there, but it’s two of the most encompassing. If you have the time, capital and resources, active investing will get you greater returns than a passive investment style. However, don’t rule out investing altogether if you are unable to be an active investor. Instead of letting your money sit in a savings account that will depreciate in value (because inflation), you are better off putting your money into a fund and never touching it for 10+ years.
Q.ai sits at the intersection of these two styles. Our portfolios are updated and rebalanced frequently, like an active investor’s, but the user themself doesn’t need to do anything. If that’s what you’re looking for, Q.ai is worth checking out.
The We Study Billionaires podcast episode, Investing & the Brain, invites neuroscientist neuroscientist John Gald to discuss the impact the brain has on investors. It digs into how your mind subconsciously processes info and the many ways our brain plays tricks on us, leading to common investing mistakes.