Active and passive investing are two approaches to managing investment portfolios. The main difference between the two lies in how investment decisions are made and how the portfolio is managed.
TLDR; Active investing involves a human investor picking and choosing individual investments to try and outperform the market. The performance of an actively invested fund depends on the skill and ability of the human making investment decisions. Passive investing typically just tracks an index with the goal of matching the market, not beating the market. The success of a passively invested fund depends on the performance of the overall assets within the fund.
What is active investing?
Active investing involves actively buying and selling securities to try and outperform the overall market, or a specific index like the S&P 500. Human investors research, analyze, and individually pick and choose what stocks to add into their portfolio, adjusting their positions based on market conditions, economic outlook, and their own judgement.
How many times have you heard this line? “I was spending every day researching and trading the market and what I discovered was that I would have just been better off investing in an index and leaving the investment alone.”
Active investing can often lead to higher returns in the short run, but can be difficult to maintain a winning portfolio consistently year over year. In the long run, passive investing tends to outperform active investors. Active investing also requires more time, effort, and expertise and incurs higher transaction costs and management fees, while passive investing uses more a set it and forget it style.
What is passive investing?
Unlike active investing, passive investing doesn’t try to beat the market. Instead, the goal is to match the performance of the market or an index. Passive investors don’t actively pick and choose individual assets to invest in, but invest into an existing group of assets by investing in index funds and ETFs.
Also read: Index Funds vs ETFs vs Mutual Funds
Passive investments don’t require constant buying and selling, saving the investor time and costs on management and trading fees. The average return of the stock market is around 10% per year, which passive investors are able to achieve in a more hands-off manner than active investors.
Pros and cons of active investing
Advantages of active investing
Higher returns
Active investing has the potential to provide higher returns than passive investing since the goal is to outperform the market by buying and selling assets that a regular index fund or ETF might not trade. However, most actively funds underperform in the long-run compared to passively invested funds.
Capitalize on market inefficiencies
Something a regular index fund or ETF cannot do is identify and trade against market inefficiencies. A smart investment manager may be able to identify undervalued or overlooked assets and take advantage of them in the short-term.
Flexibility
Because active investors are making frequent buys and sells, they’re able to quickly adjust their positions based on changing market conditions, economic outlook, and other factors, while passive investors usually just “ride the waves.”
Disadvantages of active investing
Higher costs
Because a human investment manager is spending their time researching, strategizing, and buying and selling assets in the fund, actively managed funds come with much higher fees than passively invested funds. Furthermore, you still need to pay the higher fees even if the fund loses money.
Underperformance risk
Even the best fund managers cannot consistently outperform the market every single year. The performance of an actively managed fund depends largely on the fund manager’s skill, which is challenging to consistently assess. One of the biggest risks with active investing is that you’ll end up getting lower returns than a passive approach due to the investor’s decisions.
Pros and cons of passive investing
Advantages of passive investing
Lower costs
Passive investing have lower management fees since there is no human actively trying to beat the market. Additionally, fewer transactions are made, since you’re not constantly entering and exiting positions, resulting in lower overall transaction fees.
Consistent returns with market
Since your goal as a passive investor is simply to match the market, and not beat the market, your returns closely match the overall market performance with no outside effort on your part. The stock market has historically returned around 10% per year over the past 30 years.
Hands-off investing
With passive investing, there’s no need to constantly research assets in order to adjust your portfolio positions. You simply buy shares of an index and your performance depends entirely on the performance of the assets in the index. As a result, passive investing saves you time and effort, and many beginner investors can make a return consistent to the market without having to learn how to analyze stocks.
Disadvantages of passive investing
No potential for wild gains
Since the goal of passive investing is simply to match the market, there is no potential to get above-market returns.
No protection from bubbles or crashes
While active investors may be able to identify upcoming bubbles and crashes, and timely exit their positions, passive investors will mirror the market even during speculative bubbles.
How to choose between active and passive investing
The choice between active and passive investing depends on an individual’s risk tolerance, investment goals, and beliefs about the efficiency of financial markets. Both approaches have their merits, and some investors may choose to blend both strategies in their portfolio. However, remember that even the best active fund managers have difficulty consistently outperforming the market. Many people spend the equivalent of a full-time job’s worth of time on buying and selling stocks only to end up underperforming the overall market.
Here are some things to consider when deciding between active and passive investing.
Investment goals: Is your goal to get as high a return as possible, or would you be content with consistent market returns?
Risk tolerance: Active investing comes with higher risk due to the possibility of underperforming the market.
Time and effort: Passive investing is mostly a set it and forget it approach to investing. With active investing, you’re constantly having to research and analyze the market and your asset positions to try and predict upcoming trends and movements.
Fees and expenses: Are you okay with paying higher fees for the prospect of higher returns? Actively managed funds have higher management fees and you’ll have to pay them even if the fund loses money. An actively managed fund has average fees of 0.5% to 2%. A passively managed fund has fees as low as 0.05%.
Belief in market efficiency: Active investors believe the market is inefficient and have confidence that they can identify them and trade against them. Passive investors believe markets are efficient and tend to trust that they’ll make a more consistent return over the long-run.