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All too often, individual investors are sold “trendy” high-risk investments, only to be left holding the bag when the smart money heads for the door. At the other extreme, some investors are too cautious, taking limited steps and investing in low-yield, low-risk investments. It’s tough to sift through all that dry terminology, and glossy invest mags might as well be written in Aramaic. This is probably why many investors are unaware of important differences between index investing and managed investing. Let’s take some of the unknowns out of your equation.

Index Investing
Referred to as a passive investment strategy, since there is no active manager, indexing involves investing periodically in the broad market barometers, like the Toronto Stock Exchange, acquiring a little ownership in every security listed, periodically. Here, the investor takes advantage of long-term, broad-based growth, with limited exposure to risks associated with individual company investment. One weakness is that indexing cannot protect investors from broad sell-offs in the market place.

Indexing would be used by anyone looking to smooth out the volatility of individual stock fluctuations and produce solid long-term gains. For example, if you had invested $10,000 in an S&P 500 Index fund 10 years ago, your return would be about 28%, or 2.8% per year. Now, if you turn the dial back twenty years (would that we could), the return is 232%, or about 11.8% per year. It’s clear the results improve significantly longer term.

Focus on low-cost index mutual funds and exchange traded funds (ETFs) for this type of investing.

Managed Investing
Just as we often use personal trainers to help us improve overall fitness, investment managers help us tone up our portfolio. People who consider themselves savvy investors take advantage of managed funds or investment advisors to improve their portfolio. The goal is to find a particularly smart set of money managers who can pick a limited selection of securities (stocks, bonds, etc.) from the broader markets, resulting in above-average returns. The astronomical growth of certain stocks, like Netflix (NFLX, returning 28% annually over the last ten years), demonstrates how picking individual securities can result in significantly higher returns.

Not surprisingly, these types of investments usually involve higher expenses and fees. There are also higher risks associated always with higher returns. People with large positions in big financial stocks in 2008, for example, realized unrecoverable losses with the recent crisis. Index investors would have seen temporary losses, as markets recovered rapidly.

How Does It All Fit?
The simplest way to start is by indexing. It’s simple, and any broker can walk you through the basics. Managed investments require a certain amount of vigilance, to ensure the advisor/fund manager is justifying his expense.

Also, consider your own financial situation thoroughly. If your income situation is more volatile, invest steadily and conservatively. Deploy a significant percentage of your portfolio, 40% – 60%, in income-producing investments, and favor preferred stock over common shares. If you have a more steady earnings outlook, consider a little risk in your portfolio, investing in growth stocks to 40% – 75% of your portfolio, depending on your age and your retirement savings.

You may want a little of both strategies. That’s OK. If you’re cautious, consider allocating 10% – 25% of your capital to managed portfolio and the rest of your funds to the broader indexes. Scale back on risky investing as you age or your financial obligations increase and protect your principle. Determining your risk tolerance is paramount, and no one but you can truly know what you can stomach, so take your time. Don’t let anyone rush you into anything. Free online asset allocation calculators can help you examine how your portfolio can change over time and with different risk profiles.

In the long run, you can do well by simply avoiding hype and focussing on larger, established sectors of the economy. Per the catchphrase, don’t put all your eggs in one basket — and don’t hesitate to skip any investment opportunity whose details aren’t clear to you. The bottom line: However you choose to do it, invest. Individual investors are most successful with long-term, periodic investment. Adopt a disciplined approach, and you’ll get a good feel as to why this strategy is a historical cornerstone in the investing world.

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Image courtesy of Twon.