If you are looking to build a portfolio that performs well, one of the most fundamental issues to consider is the difference between passive and active investing.
The difference between these two types of investing can be put simply. Passive investors are focused on the long term, and try to minimize the level of buying and selling in their portfolio. Active investors, as the term suggests, take a more energetic approach – buying and selling shares rapidly to try to generate the highest possible short term gains.
Both types of investment can be a valuable part of your portfolio, but in order to use them effectively you need to understand the details of each. In this guide, we’ll show you the advantages and disadvantages of active and passive investing.
- Active investing is an investment strategy in which a portfolio manager will take direct control of a portfolio. They will then use their skills to buy and sell assets – not just stocks, but bonds and other holdings – in order to maximize the returns on a portfolio.
- Passive investing is a more serene approach to investing in the stock market. Passive investors are generally looking for long-term gains, and do not mind so much if a stock goes up or down in value on a particular day.
- When it comes to choosing between active vs passive management, you must look at your personal circumstances carefully. Specifically, you should assess what level of risk you are comfortable with, and strike a balance between the two approaches in your portfolio.
Active vs. Passive Investing: The Basics
First, let’s look at passive investing vs active investing in more detail. Though the differences between these approaches can be put simply, the way that they interact can be quite complex.
Passive investing, for example, is most popular among investors who have a low risk tolerance. Most people use this kind of investment to save for retirement, or to invest money for many years. Passive investing is generally regarded as a low-risk, low-return strategy, but can be used alongside more aggressive forms of investment.
Active investment is the opposite – a strategy in which investors try to predict short-term fluctuations in the market, and make a profit from them. Active investors generally manage their portfolio themselves, using an asset management platform like Wealthface, although Wealthface can also be used for passive investing. Active investing is generally regarded as a higher risk strategy.
Active Investing: Hands-on Management for Higher Returns
Active investing is an investment strategy in which a portfolio manager will take direct control of a portfolio. They will then use their skills to buy and sell assets – not just stocks, but bonds and other holdings – in order to maximize the returns on a portfolio.
An actively managed portfolio like this requires great skill and knowledge to run effectively. Active investors must pay attention not only to macroeconomic market conditions, but also be aware of short-term fluctuations in the price of day trading stocks. This approach can realize high gains within a very short period of time, but it is also quite risky.
There are several techniques that active investors use to generate profits. Those at large institutions generally have a team of analysts who look at both the qualitative and quantitative features of a stock in order to predict its future movement. Another popular approach is “factor investing”, in which the particular “factors” that can predict a stock’s movement are used to predict whether it will rise or fall in value.
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Passive investing is a more serene approach to investing in the stock market. Passive investors are generally looking for long-term gains, and do not mind so much if a stock goes up or down in value on a particular day. As long as it ends the decade up, passive investors will be happy.
Passive investments don’t require stocks and other assets to be bought and sold frequently, and so passive investors don’t normally require the services of a portfolio manager. This makes the cost of passive investment significantly lower (in general) than the fees associated with active investment.
The primary example of a passive investment approach is the index fund. Broad-based index funds like the ones that track the S&P 500 or Dow Jones Industrial Average track the value of the stock market as a whole, and so have increased in value slowly but surely over the past century. This makes them a low-risk, low-return type of investment.
There are other approaches, however. Some of the best passive income investments are passive income stocks that pay guaranteed dividends every year, and so make a lot of sense in the long term.
Which is best for you? The Key Differences Between Active and Passive Investment
When it comes to choosing between active vs passive management, you must look at your personal circumstances carefully. Specifically, you should assess what level of risk you are comfortable with, and strike a balance between the two approaches in your portfolio.
Let’s look at the key differences between the approaches:
Passive Investing Advantages
There are a number of advantages of passive investing, and especially of passive index funds:
- Low cost: Because passive investments don’t normally have a portfolio manager, they are generally low-cost.
- Transparency: With an index fund, you know exactly which stocks your money is invested in, and these stocks change infrequently enough that you can keep track of them.
- Tax efficiency: Passive investments grow slowly, which means that the tax due in a particular year is generally quite low.
Passive Investing Disadvantages
On the other hand, passive investments have some drawbacks that can make them unattractive for ambitious investors:
- Lack of flexibility: Even if you know a stock is going to perform well, most passive investment funds won’t let you invest outside of a very specific set of assets. This means that you can miss out on big opportunities.
- Small Returns: This is arguably the biggest disadvantage of passive funds. By definition, passive funds are well diversified, and while that is great in terms of low-risk, it can also mean low returns. Passive investments might sometimes beat the market by a little, but they won’t increase massively in value unless the stock market goes through a significant boom.
Active Investing Advantages
Wharton have been one of the primary promoters of active investment, and have been instrumental in the popularity of actively managed mutual funds. They cite several advantages of active investment approaches:
- Flexibility: The biggest advantage of an active strategy is that you can quickly and easily buy stocks that you think will increase in value. This can maximize the returns on your portfolio, but also increases your risk.
- Hedging: Smart active investors can also hedge their investments. Hedging is the process of mitigating risk by using techniques like short sales and put options, and some believe that this can reduce the risks of active investment significantly.
- Tax management: Though some of the most active stocks on the nyse and the most active stocks in the nasdaq can increase or decrease in value significantly in a given tax year, this need not lead to huge tax bills. Active investors can use tax management strategies to offset their bill.
Active Investing Disadvantages
There are, essentially, two major disadvantages of active investment strategies, but they are big ones:
- Cost: Active investment portfolios come with a much higher cost than passive investments. This is due to two reasons – one is that you are paying the salaries of the team that is managing the fund, and the other is that high-frequency buying and selling can make transaction costs higher. All this results in a much higher fee ratio. Thomson Reuters Lipper pegs the average expense ratio at 1.4% for an actively managed equity fund, compared to only 0.6% for the average passive equity fund.
- Risk: This is undoubtedly the biggest drawback of active investment. Active managers are free to buy whichever stocks, bonds, and other assets they think will increase in value. Sometimes they get it right, and a portfolio will increase in value. Sometimes they will get it wrong, and you will lose money.
So which should you choose?
Well, if you look at the market as a whole, the answer is clear. Passive investment strategies work much better for most investors. In fact, only a small percentage of actively managed funds manage to perform better than the market over the medium to long term. That might be surprising, but it’s the truth, and study after study has confirmed it.
That might be a simplification of a complex reality, however. Some of the most active stocks are those that also appear in diversified index funds, for instance, meaning that they are held by the most passive investors and also traded aggressively by active investors.
In practice, the best approach is to put the money that you can’t afford to lose into passive investments, where it will likely grow slowly but surely until you are ready to retire. Then, if you are lucky enough to have money to speculate with, you can try and maximize your short—term gains by getting into active investment.
The Bottom Line
Both active and passive investment strategies have strengths, but both have weaknesses. Active investment is a high-risk, high-gain strategy, and passive investment is the opposite. Because of this, each suits a different type of investor.