The differences between active and passive investing create a gulf within the investment world. Today, there is serious debate over the viability of each approach to investing.
With the advent of new trading tech, especially mobile-centered investment applications, those who want to start investing should seriously consider the differences between active and passive investing.
There are distinct advantages and disadvantages to both investment approaches. This article will clarify the difference between these two strategies and offer advice on which may work better for you. To do that, we will cover:
- What active and passive investing are
- The advantages and disadvantages of each
- Cases when one may be better than the other
- Hands-off, active investment opportunities
The Differences Between Active vs. Passive Investing
Let’s get started reviewing the main key differences between active vs. passive investing.
What is Active Investing?
Active investing is an investment strategy that involves frequent trading. Critically, active investing is undertaken to beat the returns for a given index (e.g., the S&P 500).
People often associate active investing with Wall Street traders in TV shows and movies. Today, though, active investing can be done right at your fingertips, thanks to mobile investment apps.
There are two ways that non-professional traders tend to approach active investing:
- Simply do it yourself, when you have the free time
- Outsource active portfolio management to professionals
Actively-managed funds, such as mutual funds and ETFs, are perhaps the simplest examples of the latter. Investing in either can provide you with a complete, well-rounded portfolio that’s managed by professional fund managers. Active investing can be outsourced in other simple ways, too.
In general, active investing is the more difficult of the two major approaches. Individual active investors, fund managers, and other pros typically assess a wide range of data about every security they invest in. That means copious quantitative and qualitative data are studied – broader market, sector, and economic trends all have to be taken into consideration too.
The trade-off is that, when done well, active investing can produce significantly higher returns than passive investing.
What is Passive Investing?
Passive investing is the process of buying and holding assets for an extended period of time. It’s considered a “hands-off” approach because you choose each security then hold it through any immediate, or even long-term, ups and downs. Generally, passive investing involves taking a long (years or decades) view.
In contrast to active investing, which focuses more on individual securities, passive investing will typically involve more index funds and ETFs. That’s because these are the investments that can most reliably track the performance of major indexes such as the S&P 500. Of course, this means that, with passive investing, you can expect to (roughly) recreate the market’s returns, not beat them.
Because of the hands-off nature of passive investing, it requires far less dedication and attention. Most passive investment strategies don’t require daily or even weekly attention. Passive investing also requires far fewer transactions than active investing, which means passive investors pay fewer fees. But by the same token, passive investors don’t produce returns as strong as those of proficient, active investors.
Pros and Cons of Active and Passive Investing
Let’s review some of the pros and cons of active vs. passive investing:
The Benefits of Active Investing
Active investing implies human portfolio management – that management may be done by the individual investor, their manager, or their team of managers. Active investing portfolio managers may pick promising individual stocks or focus on specific promising sectors. Regardless of those details, active investing portfolio managers are backed up by teams of analysts who constantly do in-depth research to identify the most promising investments.
When done well, active investing can produce returns that index-tracking funds and ETFs simply cannot. By combining human cognitive power, deep market expertise, cutting-edge tech, and reams of data, active investors can assemble portfolios that consistently outperform the market as a whole.
The whole point of active investing is to allow ordinary people to benefit from the expertise of professional managers and analysts. When things are going well, and the team is solid, investment returns can beat the market repeatedly.
The Disadvantages of Active Investing
As you’ve likely figured, active investing takes a lot of work. The professionals behind the management need to be paid, and they also need to cover their overhead expenses. That’s why they usually charge fees. While their fees are often justified through the higher returns they produce, specific fee rates are always worth your close consideration.
Speaking of good times and bad times, there aren’t any guarantees that active investing will always beat the returns of a tracking index. For this reason, it’s important to look into the history of any actively managed fund you are considering.
Seeing as you’ll always pay more for active management, the fact that most actively managed funds can’t beat the indexes they are committed to beating is the major industry drawback.
The Benefits of Passive Investing
The main benefit of passive investing is how easy it is relative to the returns it usually produces. Passive investing costs little and requires less attention than active investing. It also creates better returns than most actively managed funds and portfolios, most of the time.
Another benefit of passive investing is how it provides an easier path to diversification. Passive investing strategies lean heavily on funds. That means that you’re normally investing in hundreds or even thousands of individual securities across a wide range of markets and sectors. So if one stock or other investment (or two, or a dozen) goes south, it’s unlikely to have a significant negative impact on your overall portfolio.
The Disadvantages of Passive Investing
There is nothing inherently wrong with passive investing as a strategy except for one potential challenge: if a bear market takes hold, there is no excellent exit strategy.
Passive investing portfolios are built to produce long-term results, and when the market suffers as a whole in the short term, it can be hard to find the exit. However, this concern can be tempered by the fact that market corrections, including some of the worst bear markets, have never been permanent.
The market has always recovered in the past, but there’s also never a guarantee that it will recover quickly. That means there’s no guarantee that timing will be on your side, so it’s essential to revisit your asset allocation and consider whether you’re willing to wait out a long market storm.
Passive investing won’t produce results as quickly as proficient active investing. This isn’t a problem for most passive investors, but it’s worth considering if your investment goals don’t align with the benefits that a passive strategy provides.
Active vs. Passive Investing: What Is Better for You?
Neither active nor passive investing is suitable for everybody – each strategy will be a better fit for some and a worse fit for others.
In general, active investing makes more sense if you can tolerate some extra risk for the chance at higher returns. Conversely, passive investing makes sense if you are more risk-averse.
Overall, there aren’t any guarantees when investing, regardless of your strategy. Both passive and active investing tend to produce solid returns most of the time. However, the devil is in the details, and when considering active investing in particular, it’s essential to investigate the active funds you’re considering investing in carefully.
