Active vs. passive investing
What differences are there?
- Active investing: Requires a hands-on approach by choosing short-term investments and potentially beating the market
Passive investing: A long-term solution to growing wealth by a buy-and-hold strategy
Blending of the strategies: Combining both strategies could be the best solution for investors, as there isn’t just one perfect investment strategy.
What is active investing?
Active investing is about choosing the best short-term performing investment to beat the average market return. It requires a hands-on approach and someone to act as a portfolio manager, which can be the person who owns the portfolio or a professional manager. What’s more, active investing requires frequent decision-making and monitoring of the portfolio.
A portfolio manager should have the expertise to know when to buy or sell a particular fund, stock, or asset, which requires a deeper analysis of potential investments. These analytical skills include the ability to analyze investments for price changes and returns, as well as fundamental analysis, such as analyzing company financial statements.
Pros and cons of active investing
Does active investing sound intriguing to you, and you’re ready to start investing? Before doing so, there are some advantages and disadvantages that you may want to know about. These could give you a better starting point for your decision-making process.
Pros | Cons |
|---|---|
Higher returns: Active investing has a potential for greater profits, due to the approach of beating the market averages. | Higher fees: Due to trading commissions, management fees, and other expenses, active investing involves more costs. |
Flexibility: Investors can adjust their portfolios depending on market changes or new possibilities. | Time commitment: Active investing requires a lot of time for research and portfolio management. |
Customization: Investments can be tailored according to specific goals and preferences. | Risk for human error: There’s always a chance of misreading market trends or making decisions in emotional states, which can lead to poor investments and losses. |
Hedging: Active investors can play it safe by using various techniques (e.g. short sales or put options) and by exiting funds or stocks when investments become too risky. | Greater risk: Aiming for higher returns can lead to potentially larger losses, due to volatility. |
Tax management: Investment advisors can adjust tax management strategies to individual investors by selling loss-making investments to offset taxes on high returns. | |
Expert guidance: Professional tips and insights can ease decision-making and help form investment strategies. |
What is passive investing?
In contrast to active investing, passive investing is about the long term, which means that changes to investments are not being made that often. Instead, investors buy and hold their funds, stocks, and other assets. They also have to resist the urge to react or anticipate stock market changes. This strategy makes it a very cost-effective way to invest and which can lead to financial wealth in the long run. Trading less frequently could also help investors qualify for lower long-term capital gains tax rates.
But how does that really work? As an example, investors can invest in an index fund like the S&P 500, which contains certain constituents. Whenever these constituents change, the index fund automatically changes too and adjusts its holdings by selling or buying stocks.
By owning fractions of thousands of shares for a long period of time, investors earn their returns as a result of corporate profits.
Pros and cons of passive investing
You might consider that passive investing also has its merits and drawbacks. This can give you a good basis for finding the optimal investing strategy for you.
Pros | Cons |
|---|---|
Lower costs: By investing less frequently, fewer transaction fees are incurred and passive investments have typically lower expense ratios, which are the annual fees charged by funds | Less flexibility: Passive investment isn’t designed for quick adjustments to market changes or for taking advantage of short-term opportunities. |
Broad variation: Investors have exposure to a range of stocks within an index class. | Small returns: Passive funds generally match the market and rarely outperform it, whereas active investments have the potential for higher returns. |
Transparency: You always know which assets are in an index fund. | Exposure to market risk: Investors follow certain indexes. If these indexes have downward price trends, the passive investment funds will probably have the same negative performance. |
Simplicity: For passive investments you don’t need constant research and decision-making. | Lack of control: Because they generally rely on fund managers to make decisions, investors often don’t get a say in what they’re invested in. Also, investors can’t exclude certain companies or sectors from their portfolios. |
Tax efficiency: Trading less frequently typically means lower capital gains tax. |
Active investing vs. passive investing — what’s the difference?
In general, investing has the aim of growing wealth. Although there’s one goal, it can be achieved in two ways. So, the difference between active and passive investing lies in the different approaches to managing investments.
Which way you choose depends on your financial goals. Here’s a comparison of active investing vs. passive investing:
Active investing | Passive investing |
|---|---|
Requires a hands-on approach (by a portfolio manager or another participant). | Requires a buy-and-hold strategy (with infrequent buys and sells). |
It’s about choosing the investment that performs best in the short term to beat the market. | It’s a very cost-effective way to invest in the long run. |
As a portfolio manager, you should have the expertise to know when to buy or sell and how to analyze potential investments. | It doesn’t require constant research and decision-making. |
What to consider when deciding between active and passive investing
Whether you decide on passive investing vs. active investing depends on various factors such as your financial goal, your risk tolerance, your available time, and your investment knowledge. There’s not just one perfect fit, as both strategies have their advantages and disadvantages.
For a better evaluation of your options, you might ask yourself a few questions, such as what your financial goals are or what your risk tolerance is. Depending on your investment tendency, the following questions may help you with your decision.
Active investing | Passive investing |
|---|---|
How much time do you have available for managing investments? | Are you comfortable with a buy-and-hold approach? |
How much access do you have to expert information? | Are you satisfied with returns that are in line with the market? |
Do you have confidence in the potential for long-term market growth? | |
How much time do you have before you need to access your money? |
As there isn’t just one perfect choice for investment, you might consider blending active and passive investments. It may help minimize the large swings in stock prices during volatile times. Combining active and passive investments could also diversify your portfolio and help manage overall risk.
For example, investors may allocate a part of their portfolio to actively managed funds to potentially achieve higher returns, while also including passive funds for a large market exposure and fewer costs.
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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.