When it comes to investing, there are two schools of thought – active investing and passive investing. You will find that many people are of the belief that one or the other of these schools of thought is the way to invest. If you are new to investing, you probably have no clue what the difference is between active investing and passive investing. Furthermore, you might question if it even matters. For example, is one better than the other, or is it simply a preference like boxers or briefs, jam or jelly?
While it would be nice if it were simply a preference, in reality one of these investing strategies is actually a smarter move for you to make with your money. I’ll get into the details later, but for now, let’s start off making sure we understand what each strategy believes in.
Passive Investing & Active Investing Defined
Time to talk about what each of these strategies are. I’ll give a basic definition and then get into more detail below.
Passive Investing: Passive investing 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 investing 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 Investing: Active investing 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 investing 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%.
Now that we know the differences between the two, which strategy is the better long term option for your investment dollars?
Active Investing vs. Passive Investing Showdown
As with anything in life, there are advantages and disadvantages to both active and passive investing. 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
- 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 gems out there and make the right trade at the right time.
- Professional Management: active mutual funds are run by a team of managers that oversee the funds and make decisions when to buy and sell. Since they are educated in finance, they have a higher probability (in theory) of beating the market.
- 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 more risky investments and instead invest in more safe holdings.
Active Investing Disadvantages
- 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 very rare for a manager to consistently beat the market. They may do so here and there, but not every year.
- High Fees: because of professional management, active funds tend to have higher fees since you are paying for the professional management. This eats into your returns over the years.
Passive Investing Advantages
- 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 fees are much lower, which pays off in the long run.
- 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.
- Simple: 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
- 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 pretty good return.
- 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.
There are two common misconceptions that most investors have when it comes to active and passive investing.