Which is better, active or passive investing? Anyone remotely familiar with the investment community will know that there is a constant debate raging over this particular topic. And this. debate has intensified over the last few years.
In reality, the best type of investing will depend on your investment goals.
With that in mind, let’s take a closer look at the nitty-gritty details of passive versus active investing. Once you have the information you need, you can decide for yourself which is a better fit for your portfolio.
Table of Contents
Passive vs. Active Investing
What Is Active Investing?
Active vs. Passive Investing: Pros And Cons
Passive vs. Active Investing: Which Is Best For You?
Final Thoughts
Passive vs. Active Investing
First things first, it's important to understand what the terms passive investing and active investing actually mean. Let’s get started with the basics.
What Is Passive Investing?
Passive investing is associated with a hands-off approach. As a passive investor, you're likely investing for the long term. With that, you may not be interested in making regular trades to achieve short-term gains. Likewise, you aren’t trying to beat the market with sophisticated investment strategies that require constant portfolio updates.
Instead, passive investors want to set up their investments and let the market take care of the rest. They usually investing in index funds that track particular market benchmarks. Essentially, passive investors are sticking to the idea that time in the market is better than timing the market.
Of course, that doesn’t mean that passive investors completely ignore their portfolios. In fact, regular portfolio rebalancing is an important part of any passive investment strategy. However, passive investors will likely check in their portfolio on a minimal basis of once a quarter or less.
What Is Active Investing?
Active investing involves a more hands-on approach. With an active investment strategy, an investor or their money manager watches the market constantly. As the market fluctuates, the investor looks for opportunities to improve their portfolio.
Typically, active investors are concerned with short-term gains. An active investment strategy involves a considerable amount of time and research in an effort to out-perform the market.
Unfortunately for active investors, the vast majority are unable to out-perform the market. In fact, over 75% of actively managed funds failed to beat the market over a five-year period, according to S&P Dow Jones Indices. And that number gets even worse with time: at 10 years, 85% are failing to beat the index, and at 15 years, 92% fail to beat the index...
Active vs. Passive Investing: Pros And Cons
Each investment strategy comes with pros and cons. Here’s a closer look at the advantages and disadvantages of these investment styles.
Pros Of Passive Investing
Passive investing has several advantages including:
- Lower fees: Passive funds don’t require a fund manager to pick stocks. With that, the investment fees can be considerably lower.
- Tax efficiency: Passive investors employ a buy-and-hold mentality. This creates fewer taxable events to minimize capital gains each year.
- Easy to understand: Passive funds usually have clear definitions of the assets included.
Cons Of Passive Investing
As with all financial strategies, there are some drawbacks to consider with passive investing. These include:
- Limited options: As a passive investor, you’ll likely have to choose from a selection of pre-determined indexes. Although you can work with many different brokerage platforms, the basics of many index funds are very similar.
- Average returns: Passive investing is designed to keep pace with the market. With that, you give up any chances to beat the market.
Pros Of Active Investing
There are a few potential advantages of active investing. These include:
- Flexible opportunities: An active fund manager can make adjustments to the portfolio at any time without any requirements to stick to a particular index.
- Complex investing strategies at play:Active fund managers are free to try various techniques, including market timing and short selling to boost their performance.
- Potential for above-average returns: If you or your fund manager choose a few big winners, there's a chance that your portfolio could outperform the overall market.
Cons Of Active Investing
As with all financial strategies, there are some drawbacks to consider with active investing. These include:
- Higher costs: The human element of an actively managed fund makes this strategy more expensive. If you decide to actively manage your own portfolio, you should expect to sink in considerable time costs.
- Potential for below-average returns. As we mentioned above, most actively managed funds don’t beat the market. So you may end up paying more for an active fund that underperforms a less expensive passive fund. Or, if you're active investing yourself, you'll under-perform.
Passive vs. Active Investing: Which Is Best For You?
Both passive investing and active investing can be appropriate strategies for investors. However, you’ll need to decide for yourself which is the right option for you.
If you want to take a hands-off approach to investing, then a passive style is the better choice. You can expect reasonable returns that are consistent with market averages over the long term. Additionally, you can ensure that you aren’t overpaying for mutual funds or ETFs.
On the other hand, if you want to create a personalized investment experience and have the time to commit to this strategy, then active investing might be right for you. Investors with a short-term mindset could also benefit from an active approach.
Before you dive into an active approach to investing, take some time to learn the basics. Without a basic understanding of the stock market, it's better to stick to a passive approach until you have enough time to commit to learning this skill.
Final Thoughts
As an investor, a passive or active style may be best suited to your needs. Importantly, neither type of investing is outright better than the other. However, each strategy will serve the needs of a particular type of investor better.
Before you decide which one is best for you, take some time to consider your investment goals. Need some help deciding which investment strategy is right for you? Take a look at our ultimate investment strategies guide.
