If you listen to analysts, brokers, or traders, you’ll hear thousands of theories and philosophies about proper investing methods. The two broadest categories that encapsulate most of them are active investing and passive investing.
What is active investing?
At its core, active investing is a practical approach. You invest in securities and keep an eye on them. You monitor them after you buy them and actively look for stocks that take advantage of market conditions.
An active investor strongly believes that they can outperform the market by capitalizing on price movements, events, and conditions. A good example might be investing in Gilead Sciences two months before earnings fall because he believes a new drug will increase sales. Once the profits are released, he sells the pick.
Another example might be investing in an actively managed fund, where portfolio managers actively pick stocks, monitor events, and make moves. This differs from buying an index fund that largely follows the market. Many mutual funds operate this way, and some ETFs do as well, although generally to a lesser extent.
What is passive investing?
Passive investing is more than you might imagine Warren Buffet does. Passive investing involves researching a stock, fund, or ETF and then investing in its long-term potential. Basically, you “buy and hold” stocks that you think are priced below their intrinsic value based on your fundamentals.
A passive investor is not concerned with capitalizing in the short term or a particular event, but rather has faith in the long-term potential of an investment over a longer period of time. A passive investing strategy operates on the assumption that long-term market efficiency can and will produce the best results.
Active vs. Passive Investing: What Are the Differences?
The differences here are quite clear. Active investing involves actively paying attention to the market and your investments. If something happens that creates incentives to add more shares to your position (or sell shares), you do so.
Active investing has no problem with short-term gains. That is not necessarily to say that an active investor cannot take a long position, but the strategy would generally cause someone to change their positions more frequently than a passive investment strategy.
Passive investors do not check their positions on a daily basis. If they buy 1000 shares of Ford, they keep that big dividend and let the position build up over time with the market.
An active investment strategy in Ford, on the other hand, might include cutting or increasing positions on events like “strong July truck sales” or things of that nature.
return potential
Active investing definitely creates the opportunity for higher returns. By reacting to events and developments, one can take advantage of situations to increase returns and/or avoid broader market reversals.
This is why active asset managers within areas like mutual funds and hedge funds have been able to outperform the market at different times. However, for every active investor who outperforms the market, there are probably 10 who underperform.
Success is not guaranteed and it is not an easy game. If it were, there would be a lot more billionaire investors. If your instincts are wrong in a short-term position, you can lose a lot of money quickly.
If you sell too soon due to a sudden price increase, you may miss out on the 30% expansion that will occur in the next 12 months. At the fund or portfolio level, the lack of index linkages creates the potential for you to outperform the market and underperform.
Passive investing limits your potential for big profits. By buying and holding, you are trading at the pace of the market, whether in reference to a single security or a fund. Most people invest in funds rather than individual stocks or bonds. These funds are usually linked to an index that tracks a sector or industry. Costs and structures vary a bit, but that’s the general idea.
When you buy these passive funds, you know what the holdings are and you’re ready to ride with that group as it trades within the market. That said, because these funds are index-linked within the market, they substantially reduce the risks of underperforming benchmarks. It is very coincidental that a passive strategy fund beats the market by a lot.
You could make the counterpoint that “Buffett does it.” That’s true, but most of the big profits from him were made by buying whole or bulk parts of companies, using traded preferred stock, with different dividends. He also buys real companies instead of indices.
Costs and headaches
Active investment strategies definitely cost more in terms of transactions. On an individual level, constant buying and selling will increase your transaction fees. At the fund level, investing in actively managed funds increases the costs associated with portfolio managers taking the time and effort to make decisions as well as transactions. In other words, actively managed funds have higher expense ratios than passively managed funds. This creates the need for active strategies to produce higher-than-market overall returns to offset the costs associated with it.
Passive investing eliminates much of that headache. Because you are essentially investing in the market, you can buy index funds and hold them. Even at a singular security level, a passive investor is not going to trade Ford stock. They will keep it and enjoy the dividends and price appreciation in the long run. On a broader level, it also removes much of the cost for fund managers and analysts. Since index funds and ETFs passively track indices, investors incur fewer expenses to manage them.
What is the best investment method?
The merits of either strategy largely depend on the business cycle and market conditions. Prior to 2008, when things started to get very shaky, an active investment strategy would certainly have helped reduce risk in many areas.
The decision also largely depends on your personal knowledge. I absolutely prefer active to passive investment management. Of course, this definitely goes against the pack these days, but I just find that I get better results when I’m active in my positions.
Being younger, I work with smaller amounts of capital. To that end, I look for bugs in the market where I can capitalize on. Some years, I beat the market. In other years, I have lost that game. So it all comes down to your considerations of risk and the ability to outperform.
You certainly need a lot of time, research, and background to make an active investment properly. Therefore, the average person who is simply looking to add to their retirement is likely to opt for a passive investment strategy. If you don’t have the time to review your portfolio every day, read about all the events and economic conditions surrounding your investments, and then do the due diligence required to make the right decisions in terms of buying and selling, then active investing is simply too much to handle.
Giving up individual stocks, even owning an actively managed fund, takes knowledge and time. You have to research your portfolio managers. You have to research their properties and past history if you want to make sure you’re not making a mistake.
Due to the extra work and risk, passive investing strategies are probably the best option for the average investor. You’re helping to make sure you don’t experience a dip below market levels, and you’re keeping your business and tax costs down.
Not all active managers beat the market and the average investor simply doesn’t need that headache. That doesn’t necessarily make passive investing better, as you’re certainly reducing your return potential. It simply means that you are decreasing the risk.
