How Does the Investment Market Work?
I’m going to keep this simple!
Think of the investment market as the place where all the buyers and sellers of an investment meet up to trade. Of course, it’s not a physical place, it all happens on computer screens across the world.
Each buyer and seller is hoping to get a good deal. They base their views on information that’s available about the investments they’re buying and selling. It’s just that they’ve come to different conclusions.
No information is hidden (if it was, that would be called ‘insider trading’ which you’ve probably heard of) and is available in the public domain. Anyone can get it.
Effectively, these traders are scrapping it out between themselves. Sometimes they win and sometimes they lose. It can be ruthless!
What’s in it For You?
You’re on the side-lines watching all this. Actually, your invested money is on the side-lines. The result of the trading is the fair market price for the ‘thing’ they’re competing over which will be the shares or bonds you own in your investment funds.
Multiply this activity millions of times a day and, even though there’ll be casualties, the net effect is that the overall value of the market tends to rise over time as the collective successes mount up (but not too much because they’re diluted, to a degree, by the collective failures). That’s what you want. You don’t want things getting out of hand.
Passive Investing
If you allow your money to be invested in line with what the market does (that’s passive investing), you’re not really making much in the way of investment decisions.
You take the view (or, rather, your trusted adviser takes the view) that the investment markets work quite well on their own. Follow those markets (by using what are called tracker funds) and you should see success.
Taking this approach means you won’t have to keep chopping and changing things and the costs of investing are likely to be low because there isn’t actually that much to do. Make sense?
Active Investing
If you’re in an actively invested fund, something different is happening. The fund manager thinks they can beat the market. They’ve identified what they think is a weakness in the market and they try to exploit it.
They also try to buy-in and sell-out at optimum times but, in reality, no-ones knows (except history or a crystal ball) when the optimised times for this are!
There are various mechanisms for active management but, essentially, it’s based on guesswork. There’s no tried and tested formula. Sometimes active fund managers are right and sometimes they’re wrong.
What does tend to happen is that they do a lot of trading. A lot of buying and a lot of selling to try to create positions where they feel they can beat the market. This costs you, the investor, money and gives no guarantees for success.
Mountains of studies have shown that, once the cost of active management is deducted from the growth they’ve achieved, the returns active fund managers achieve are below the market. So, what was the point? A very good question!
My View
And this is just my view! The people who tend to win when it comes to active investment management are the fund managers because they charge fees for what they do.
I’m not saying they’re bad people but, when you look at their track record, it’s not particularly amazing and certainly, overall, no better than what the market delivers ‘naturally’.
That’s why I tend to favour a more passive approach to investing. It’s simple, it’s low cost and, over time, it works perfectly well.
Linking it to Your Goals
The key is always to remember why you’re invested in the first place and what you need / want your invested money to do for you in the long-run. This should drive how your money’s invested.
It can get quite complicated but I hope I’ve explained things in terms we can all understand.
Happy investing!