When it comes to investing, there are two schools of thought, active investing and passive investing.
Knowing which one is right for you is critical to your investing success.
Pick the wrong one and there is a high likelihood you end up losing money.
Pick the right one and there is a high likelihood you end up making money and will be successful in the stock market.
But which one is right for you?
Only you can answer that question. And this post is going to help you figure it out.
By the time you are done reading this, you will know without a doubt whether active investing or passive investing is right for you.
From there, all that is left for you to do is open an account with the right broker and start investing your money.
Let’s get started looking at both active management and passive management in detail so you can pick the best one for you and your goals.
Active Investing vs. Passive Investing: The Best Choice For You
Passive Investing & Active Investing Defined
Before we get into each of these investing strategies in detail, we need make sure you have a solid understanding of them.
Passive management involves either buying investments that track an underlying index or creating an asset allocation and sticking to it for the long term.
For example, investing in a mutual fund or ETF that tracks the S&P 500 Index is a form of passive investing.
If you put your money into the Vanguard 500 Fund (VFINX), you are investing passively. This is because the mutual fund’s goal is to simply return what the S&P 500 returns every year.
Another form of passive management is setting an asset allocation and sticking with it for the long term.
For example, if you were to pick an allocation of 60% stocks and 40% bonds, you stick with this allocation regardless if the market is rising or falling.
Active management involves ongoing buying and selling actions by an investor. Active investors purchase investments and continuously monitor their activity in order to exploit profitable conditions.
It also can mean changing your allocation based on what the market is doing.
For example, in terms of buying and selling, you are looking to make a short term profit on the price swings of a stock.
You actively are trading investments either daily or weekly in an attempt to maximize profits.
Another form of active management is changing your asset allocation.
For example, you might have a portfolio made up of 60% stocks and 40% bonds, but fear a recession coming.
As a result, you reduce your stock exposure to 40% and increase your bond holdings to 60%.
Doing this will help protect your money from losses should the market drop.
Now that we know the differences between the two investing strategies, which strategy is the better long term option for your investment dollars?
Active Investing vs. Passive Investing Compared
As with anything in life, there are advantages and drawbacks to both active management and passive management.
I won’t go through the entire list as some of them can get fairly technical. Instead I will keep it basic and only cover the most important points for both.
Active Investing Advantages
#1. Potential For Higher Return
Since active investing involves the buying and selling of investments, you can potentially outperform the market if you are able to find some undervalued stocks out there and make the right trade at the right time.
#2. Professional Management
Actively managed mutual funds are run by a team of managers that oversee the funds and make decisions when to buy and sell. Since these managers are educated in finance, they have a higher probability (in theory) of beating the market.
#3. Able To Play Defense
When the market turns south, a manager of an active fund is able to play defense to some extent. This means they can sell off some riskier investments and instead invest in safer holdings, like bonds or cash.
Active Investing Disadvantages
#1. Typical Below Average Return
While I noted above that the managers are educated in finance, they should be able to beat the market. Unfortunately they don’t. In fact, it is rare for a manager to consistently beat the market. They may do so here and there, but not every year.
Here is a great chart showing the likelihood of beating the market in one year, over 5 years, over 10 years and over 25 years.
As you can see, as you invest for longer periods of time, your chances of consistently beating the market dwindle.
Here is another way to look at the difficulty of consistently beating the market. It is called survivorship bias.
When most studies are done that look at the percent of funds that beat the market, they only look at funds that are currently in existence.
But every year, mutual funds are closed due to under performance. When you take these closed funds into account, you get a true picture of the chances you have of beating the stock market.
Below is a great chart from Stands & Poor’s showing just how difficult it truly is to beat the market consistently.
At the end of the day, your best odds at beating the market are to stick to large cap funds. But even then, you have less than a 50% chance at success.
#2. High Fees
Because of professional management, actively managed funds tend to have higher fees since you are paying for the professional management. This eats into your returns over the years.
A little later in this post, I’ll give examples showing just how much higher fees cost you.
Passive Investing Advantages
#1. Low Cost
Passive funds don’t have professional managers that need to pay attention to the market and make trades and modify holdings on a regular basis. They simply invest as the underlying index is set up. Therefore, the management fees are much lower, which pays off in the long run.
#2. Get What The Market Gives
You are never earning less than what the market returns when you invest passively. You are always going to get what the market returns, be that good or bad.
Passive investing is simple. You pick an allocation and some investments and you are pretty much done.
You don’t have to monitor the market daily to make any changes or try to take advantage of price swings.
Passive Investing Disadvantages
#1. Never Beat The Market
While a benefit is always earning what the market does, you never beat the market. To some, this is an issue, but if the market returns on average 8% annually over the years, that is a solid return.
#2. Lack Of Action
When the market drops, you are stuck with your allocation and investments since you aren’t trading based on what the market is doing. To some, this makes investing boring.
There are two common misconceptions that most investors have when it comes to active management and passive management.
#1: Higher Fees Means Better Performance
For active investing, many investors assume that the higher fee they pay means better performance.
After all, we’ve been told all of our lives that you get what you pay for.
Unfortunately this is not the case when it comes to investing.
As I noted above, most professional fund managers can’t beat the market on a regular basis. So why pay them more for mediocre performance?
Don’t make the mistake of thinking paying more for your investments means better performance or a higher return. It doesn’t work that way.
You are better off paying a lower fee and taking the return the stock market gives you.
Here is why. Let’s say you invest $10,000 for 25 years and it earns 8% annually. But it has a management fee of 1.25%
After 25 years, you have roughly $50,000 invested and you have paid a little more than $8,000 in fees.
On the surface, this might not seem like a big deal.
But let’s run the same scenario only this time you pay a management fee of 0.05%.
After 25 years you have over $67,000 invested and you have paid $392 in fees.
Now you see why fees matter.
By making the choice to pick the fund with the lower management fee, you saved yourself over $7,700 in fees and your account value is over $17,000 higher.
#2: Buy And Hold Means Set And Forget
For passive investing, many investors assume once you set up your portfolio you are done and never touch things again.
This is wrong.
You still monitor your portfolio and make adjustments as the market moves. This is called rebalancing.
When stocks rise in value, bonds tend to fall. So your 60% stock, 40% bond portfolio is now a 70% stock, 30% bond portfolio.
You need to make adjustments to get it back in line. Otherwise you take on too much or too little risk and end up not achieving your goals.
While passive investing involves less work, there is still some monitoring that needs to be done.
Which Investing Strategy Is Better Long Term?
Over the long term for most investors, passive investing is the better choice.
The fees you pay are lower and you are always getting what the market returns. You never under perform the market.
While it is true you don’t take a more defensive stand when the markets drop, consider this.
Most investors can’t time the market anyway.
They sell too late after a drop and they buy in too late after the rise.
Here is a great graph showing the emotional roller coaster most investor’s experience.
Most investors will sell around the time of panic, which is after most of the losses have occurred.
Just as bad, they won’t buy back in until most of the gains have been realized.
Look at recent history as another example of this.
The stock market bottomed during the Great Recession in February 2009. Most investors had just gotten out after the damage was done.
But then the market turned around and started its recovery. From 2009 through 2012, the market was up close to 60%.
Since the lows of 2009, the stock market is up over 300%!
This means if you had stayed invested during this entire time, you would have earned all of you losses back and made a lot of money.
Yet most investors still were too scared to invest in the stock market.
And before you think professional investors have better luck, think again.
Remember the charts from above? They cannot beat the market consistently. They can do it for a year or two, but always revert back to the mean and underperform.
Why bother chasing returns of active management when you can make your life that much easier by investing passively?
Interestingly enough, you will find studies talking about the benefits of active investing. Sadly these studies are all funded by Wall Street.
All of the independent studies done on the subject conclude that passive investing is the smarter choice.
And why does Wall Street want you to invest actively?
It’s all about the money.
The more you trade, the more they make in trading fees and commissions.
Even if you are in a mutual fund and aren’t doing the trading, the fund manager is and is paying fees.
And don’t think for a second those fees aren’t passed on to you.
So why do many investors choose active management? It is the sexier choice.
People want to talk about how their investment grew 20% last year.
No one wants to hear about passive management. It isn’t glamorous. It’s very boring.
But just like the fable of the tortoise and the hare, the winner isn’t the sexier choice.
Which Investment Strategy Is Right For You?
I will admit that I am biased towards passive management.
Why spend all the time researching and picking stocks, then having to keep current on what is happening in the market when you can just invest and forget about it?
When I think about my free time outside of work, I would rather spend it with my friends and family than researching stocks and figuring out my next trade.
If you feel the same way, then passive management is the best option for you.
If on the other hand actively researching stocks and trading all day interests you, then active management is the best option for you.
Let’s look at how to get started with both options.
How To Get Started With Passive Management
You’ve decided that passive investing if the right choice for you. Now you have to figure out the best way for you to get started.
All that is involved in a passive investing strategy is picking out the right investments and setting up an automatic investment plan.
You can go about this in one of two ways:
#1. Invest with a robo-advisor
#2. Do it yourself
Investing with a robo-advisor is a perfect option for the majority of readers because it takes most of the work out of your hands and allows the advisor to do the work.
All you have to do is answer some questions so you can be placed into the right portfolio for your goals, and then set up an automatic investment plan.
My favorite robo-advisor is Wealthsimple. They make investing easy for you and they are innovative.
Just take 10 minutes and Wealthsimple will put you in the right portfolio based on your goals and risk tolerance.
All that is left for you to do is to set up a monthly investment amount.
Then Wealthsimple will invest your money, rebalance your portfolio, and reinvest dividends for you.
There is nothing left for you to do!
And Wealthsimple goes one step further in making investing easy. You can choose to invest your spare change by having Wealthsimple round up your purchases.
When you make a purchase, Wealthsimple will round up the purchase to the next dollar and invest the spare change.
Over time, this rounding up of spare change can have a dramatic impact on your money.
For example, if you have $500 invested annually thanks to round ups, which is easily done, after 20 years at 8% growth you have close to $25,000 just from investing your spare change!
This is in addition to what you are investing monthly too!
To get started with Wealthsimple, click here.
If you want to invest on your own, then I suggest you follow a basic three fund portfolio.
You may also hear this called a lazy portfolio.
By investing in a three fund portfolio, you will be fully diversified and will be able to easily stay on top of your investments.
Just be certain your passive investment portfolio includes the following:
- S&P 500 Index Fund
- International Stock Market Fund
- Total Bond Fund
Once you have this passive investment portfolio set up, all that is left to do is add new money on a regular basis.
How To Get Started With Active Management
To get started with active investing, you have to make a decision first. You need to decide what active investment strategy you are going to follow.
I’ll keep things basic and only talk about fundamental analysis and technical analysis.
In a nutshell, fundamental analysis involves analyzing a company’s financial statements.
This allows you to see how the business is performing, including:
- Are sales increasing or decreasing?
- Have assets receivable increased or decreased?
- How has inventory levels changed over a few years’ time?
You can then begin calculating ratios and comparing those to other firms within the same industry. This will give you something to compare the numbers against.
You will be able to quickly see if the company you are analyzing is performing better or worse than its competition.
From there, you move away from calculations and have to look more at the business as a whole as well as the economy. You may be looking at a company with strong financials, but is it in an industry that is evolving.
For example, look back at Blackberry. They owned the smartphone arena. They focused solely on corporate clients.
But Apple and Google entered the market and targeted consumers and slowly worked their way into corporate America. Now, Blackberry is struggling to survive.
Looking only at their financials, you might not see the struggles coming. But after analyzing the landscape, you might have seen the proverbial writing on the wall.
In order to perform fundamental analysis correctly, you need to look both at the financials of the company as well as outside events to determine if a stock is a buy or not.
Forget everything I just told you about fundamental analysis. None of it applies to technical analysis.
Technical analysis is the process of studying the chart of the stock price of a company to determine if the stock is a buy or not.
Technical analysts are often referred to as “chartists” because they study charts to find investments.
They study the charts to look for market trends and patterns to determine when a stock is trading for less than it should be.
Additional techniques used by technical analysts include moving averages, regressions, relative strength index, and business and market cycles.
The belief is that emotions are present in the stock market and that the market repeats itself.
By studying charts, the hope is to identify the points when history is going to repeat itself, act on it, and profit from it.
Once you determine your active investment strategy, the only thing left for you to do is find the best broker for you.
My pick for best broker for active traders is Ally Invest.
I like them because they have competitive pricing on trade commissions and if you trade frequently, you can get a lower rate than advertised.
In addition to competitive commissions, they also offer endless tools an active trader needs to be successful.
To get started with Ally Invest, click here.
The Must Have Tool For All Investors
Before I wrap up this post, I want to mention a tool that any investor, whether you are into passive management or active management, needs to use.
It is called Personal Capital.
Why do I encourage you to use it? It gives you insights into your investments and portfolio that you can’t get anywhere else for free.
I used to work for a high net worth planning firm. We offered our clients a lot of tools to help them with their investments and everything we offered, Personal Capital offers.
The difference is that to get access to these tools with us, you needed to be a client. This meant you needed to be investing millions of dollars with us.
With Personal Capital, you don’t need to invest anything with them. Or pay them. The service is 100% free.
Here is a list of what you get at no charge:
- Portfolio review
- Investment checkup
- Retirement planner
- Investment fee analysis
- Net worth tracker
- And more!
This app is as powerful as you can get and I can’t say enough positive things about Personal Capital.
To get started and open your free account, click here.
At the end of the day, the debate between active investing and passive investing will never end.
You will always have people in favor of one or the other investment styles.
But what is most important is that you pick the investing strategy that is the right fit for you.
As I mentioned, I am all about index investing. I would rather invest passively and spend my free time with friends and family.
I have a friend who loves charting the market and finding undervalued stocks. Doing this excites him and he makes money doing this.
But it is a lot of work.
As long as you pick the right strategy for you, you greatly increase the odds of success and you building your wealth by investing in the stock market.