Active and Passive Investing
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What is active investing?
Active investing is investing based on an independent assessment of each investment’s worth—essentially, trying to choose the most attractive investments. This commonly means investing in funds whose portfolio managers are selecting investments, but you can also do it yourself, picking stocks you think will do well. Generally, the goal of active managers is to “beat the market,” or outperform certain standard benchmarks. For example, an active investor’s goal may be to achieve better returns than the S&P 500.
Active investing is a hands-on investment approach. Someone – either a money manager or you, is watching the market and changing the portfolio based on what they believe will bring the greatest potential returns given market conditions. Active investors usually do a lot of research, taking into consideration how market trends, the economy, and politics might impact the best time to buy or sell. While this may seem straightforward, even advanced portfolio managers struggle to out-perform the markets consistently over long periods.
An example of a popular active investment product is a mutual fund, which can include stocks, bonds, and money market instruments. Hedge funds are another example of a commonly mentioned active investment product.
What is passive investing?
Passive investing is typically a less involved investing strategy and one that’s more focused on the long-term. Passive investors aren’t constantly trading in an attempt to profit off of short-term market fluctuations. Instead, they usually add money to their portfolios at regular intervals, whether the market is up or down. Typically, passive investors believe it is hard to beat the market, but if they leave their money in, getting the market return over time will be enough to reach their investment goals, with lower fees and less stress along the way.
Passive investors don’t undergo the process of assessing the value of any specific investment. The goal of a passive investment manager is to match the performance of certain market indexes rather than trying to beat them. Passive managers simply seek to own all the stocks in a given market index, in the proportion they are held in that index.
Index funds are one of the most common ways to invest passively. They hold pre-selected lists of securities like stocks and bonds designed to track the performance of a particular index. As an example, if a passively-managed index fund is set up to follow the performance of the S&P 500 Index, then if the S&P 500 gains 9.72% in a year, that index fund should return very close to 9.72% (though it will usually be a little less due to fees). Most ETFs are set up as index funds, though there are many index mutual funds available as well.
Passive Investing Benefits
- Lower fees. Because there’s nobody actively picking stocks on your investments, passive investing may result in less overhead and therefore fewer and lower fees.
- Tax efficiency. Since they’re usually not buying and selling on the regular, passive investors are typically not subject to large annual capital gains taxes, which are taxes on your profits from selling assets that you’ve had for more than a year.
- Transparency. By looking at your portfolio, you’ll be able to see exactly which assets are included in a fund.
Passive investing drawbacks:
- No outperformance. Passive investments should never outperform the market, so you might miss out on larger gains that active investing could potentially offer.
- Less control over your portfolio. With a passive strategy, you’re usually buying into a set collection of securities, so you won’t easily be able to make adjustments if certain sectors or companies become too risky or are underperforming.
Active Investing benefits:
- More flexibility. With active investing, portfolio managers and investors aren’t required to hold specific positions, so they can take advantage of more trading opportunities.
- Risk management. Unlike with passive investing, which is forced to ride the waves of the market, active investors can easily get out of certain holdings and market sectors if deemed appropriate.
- Possible Outperformance. Active investing always gives the possibility (even if unlikely) of outperforming the market.
Active Investing drawbacks:
- Higher fees. Because you’re paying someone to constantly keep their eye on the market and manage your money accordingly, active investing can be more expensive –. And fees, even seemingly small ones, could eat into any returns that you do have.
- Uncertain performance. There’s no way to know with certainty how well a fund will perform. Many active managers fail to beat the market after accounting for expenses.
- Significant underperformance possibility. With a do-it-yourself active strategy, you run the risk of substantially underperforming the markets. While you save on management fees, the indirect costs of having a part-time portfolio manager can far exceed the 1-2% fee charged by active funds.
Which is better?
Passive investing is best when:
- You’re working with a long timeline.
- You want to minimize fees.
- You’re able to mentally commit to it. When you passively invest your money, especially over a long period of time, you’re most likely going to see a lot of ebbs and flows in the market. If you don’t feel the need to jump in and make moves with your money every time the market takes a dip, passive investing may work well for you.
Active investing is best when:
- You want to make frequent trades with your money.
- You're looking for a short-term profit through outperformance.
- You’re interested in investing in niche markets. When you or a money manager is tapped into emerging companies or sectors, you may be able to spot rare investing opportunities and act on them via active investing.
Overall, investors may be able to benefit from mixing both passive and active strategies in a way that leverages the most valuable attributes of each. By focusing on low cost passive strategies combined with appropriate active management to enhance returns and manage risk and liquidity, you can construct a portfolio with both active and passive elements that meets your personal investing priorities and goals.