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Investment Strategy: Active vs. Passive Investing

Introduction

In selecting the best investment strategy number of factors will be taken into consideration. One of the critical factors that will be taken into consideration is the knowledge of the investor about the market performance. This is because without the knowledge about performance of the market then some strategies may not be relevant to the investor. The other factor needed to be considered is the need for liquidity of the investor (Lundin, 2004).

Investment strategy

In consideration of the state of these investors, the investment strategy adopted will be either passive or active. Active strategy involves picking up undervalued investments with the hope that the market will change in value so that you can sell them to make a profit. Passive strategy is a buy and hold approach where the investor buys the stock sand hold them for a longer period with annual returns as the benefits that the investor benefits( Sharpe, 1970). In consideration of these facts, I will advise the investor to take passive investment but the investment initially should be made on companies that have good reputation. There are many factors that make passive investment the best for this company. Passive investment does not require regular professional input in determining the earnings that will be accrued from the investment (Fisher & Jordan, 2006).

Passive management strategies provide investors with a broadly diversified way to participate in the stock and bond market. Second, investment can be done at less cost – lower brokerage and management costs – because stocks in index funds are not actively traded. Passive implies that they are virtually unmanaged their performance will mirror the moods and swings of the stock and bond market (Fisher & Jordan, 2006).

The alternatives of investment strategies and risks

In choosing the best alternative to invest by Beatrix risk is the most important aspect to choose. In this case, passive method of management of bonds and equities has less risk as active because the strategy of buying undervalued bonds and stocks with the hope of the market catching up will be very risky especially this moment of economic crisis where everything including investments is having a downward trend. However in reducing the risk in passive investment strategy the portfolio needs to be immunized i.e. the duration of the portfolio should be made equal to investment who horizon. However the portfolio will be immunized against interest rate changes only if the yield curve is flat and any changes in the yield curve are parallel changes (Harrington, 1987). Recall that duration is a measure of price volatility for parallel shifts in the yield curve. If a change in interest rates does not correspond to this shape-preserving shift, matching the duration to the investment horizon will not ensure immunization; that is, the target yield will no longer be the minimum realized yield for the portfolio (Gapenski & Brigham, 1994).

The effectiveness of immunization strategies based on duration clearly demonstrates that immunization does not work perfectly in the real world. In the first study of immunization, Fisher and Weil found that the duration based immunization strategy would have come closer to the target yield or exceeded it more often than a strategy based on matching the maturity of the portfolio to the investment horizon even after considering transaction costs (Fisher & Jordan, 2006).

The divergence of the realized yield from the target yield is due to the assumption that the yielded curve is flat and changes only in parallel fashion. Several researchers have relaxed this assumption and developed measures of duration based on a yield curve that is not flat and does not shift in a parallel fashion (Gapenski & Brigham, 1994).

Performance measures of portfolio

It should be observed that prior to the development of these measures, portfolio managers performance was measured essentially by observing the rates of return they were able to earn over time. It was necessary for them to demonstrate that their rates of return equaled or exceeded the returns of an unmanaged portfolio that is either a portfolio constructed by random to choice or a portfolio that represented the returns of the market as a whole and then was held for the duration of test period. Another possible measurement of portfolio performance is to check if the manager was successful in obtaining a beta for the invested portfolio that was consistent with the objectives of the investor for his individual portfolio (Lundin, 2004). Another factor to consider in portfolio management is to evaluate the portfolios managers’ ability to completely diversify away of unsystematic risk. Because e this non market risk can be completely diversified away in a properly constructed portfolio, an efficient market will pay only for the market or systematic risk. In fact, several of the performance measurement techniques incorporate this belief (DeFusco, Dennis, Pinto, Anson , and Runkle, 2007).

Recommendations

The optimal portfolio is chosen, should be managed semi-passive to ensure the investment does not deteriorate in value. It should also ensure the investment brings in the much needed returns. Therefore a conservative reinvestment strategy should be in place to ensure returns are better and principal is not eroded (Harrington, 1987).

References

  1. DeFusco, R.A., Dennis W. M., Pinto J. E., Anson J. P., and Runkle, D. E. (2007). “Quantitative Investment Analysis” J. Wiley and Sons
  2. Fisher D E. & Jordan R J (2006) Security analysis and portfolio management, prentice hall of India private limited
  3. Gapenski l, Brigham E; (1994) Financial Management: Theory and Practice; Dryden Press. Hall, 7 th Enhanced Media Edition,
  4. Harrington R.(1987); Modern portfolio theory 2nd ed. Englewood cliffs, N J: Prentice Hall, 1987
  5. Lundin, M. (2004): “Tactical Asset Allocation and the information ratio” Journal of Asset Management 4, (5)
  6. Sharpe, W.F (1970). Portfolio theory and capital markets. New York: McGraw-hill

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Essay4Business. (2022) 'Investment Strategy: Active vs. Passive Investing'. 17 April.

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