When you start investing, you can choose between an active and passive investing approach. But which one is better to become a successful investor?
There is a heated debate in the investing world: Should you follow an active or passive investing strategy?
Most people tend to have strong opinions and are either proponents of the active or passive approach. Therefore it can often be hard to receive unbiased information on the advantages and disadvantages of active and passive investing. However, as a beginner investor, you should learn more about the differences to make an informed decision.
The difference between active and passive investing is a fundamental investing principle. In this post, you will learn about the differences, as well as the pros and cons of both approaches.
The most significant difference between an active and passive investment approach is, as the name indicates, how much time you need to dedicate to managing your investments. Active investors have to perform their own research, while passive investors rely on copying established benchmarks or investors.
Both active and passive investors measure their success against a standardized benchmark, like the S&P 500. Active investors try to beat the performance of these benchmarks. Contrary, passive investors aim to duplicate the performance.
You actively invest whenever you perform your own research and pick your own investments. Alternatively, you are also actively investing when you invest into actively managed funds where investment managers hand-pick the fund's investments.
To successfully invest as an active investor, you have to dedicate your own time to research investments based on quantitative and qualitative data. You will also need to understand the broader market and economic trends. Based on this research, you will have to find the most attractive investment with the lowest risk and highest reward. The goal is to outperform the performance of the market or a subset of it.
Once you perform your investment analysis, you will have a portfolio of individual hand-picked investments. Successful active investing requires you to be right more often than wrong about the future of those investments.
But not only do you need to perform thorough research, you also need to keep your emotions in check. In the long term, investments are always priced based on their fundamental value. However, in the short term, they can be affected by various factors, such as news coverage and economic or political trends that can cause severe market fluctuations.
Don't panic-sell in these situations! Instead, reevaluate your research and convictions about the investment and only sell if it results in a different outcome.
Contrary to active investing, you don't have to research and pick your investments when following passive investment strategies. Instead, you invest in a diversified portfolio that mirrors the performance of a benchmark, like the S&P 500.
These benchmarks, also called market indexes, track the performance of a subset of the market based on standardized rules. For example, the previously mentioned S&P 500 tracks the performance of the 500 biggest publicly-listed companies in the USA.
As a passive investor, you will usually invest in passively managed index funds or exchange traded funds (ETFs). The funds will invest into market indices so that you don't have to spend any time into researching individual investments. Whenever a new asset joins the index, the fund will purchase it to become part of the fund's portfolio. Similarly, when an investment leaves the index, the fund will sell it. As the fund will own hundreds of assets, you will benefit from the overall market's upward trajectory of investment prices.
Usually, you will regularly purchase more shares from these funds and follow a long-term buy-and-hold strategy. As a result, you will benefit from an effect called dollar-cost averaging. As you buy the shares based on a schedule rather than the current price of the investments, you will be less affected by price fluctuations. You don't have to worry about the fund being cheap or expensive and instead average the cost of your investment.
While passive investing doesn't allow you to outperform the market, you will be guaranteed to receive the average return based on the selected benchmark. In addition, you benefit from lower fees and expenses due to the lack of human portfolio managers.
Now that you are familiar with the differences between active and passive investing, let's look at the pros and cons of each investing strategy.
Following an active or passive investment strategy depends heavily on your personal investment objectives. You should consider the following aspects when making your decision:
If you don't want to spend a lot of time researching and analyzing your investments, a passive investing strategy may be better. By following a market index, you receive exposure to individual sectors or regions at a low cost without putting time into research. Contrary, if you want to research your investments and know in detail what your money goes into, an active approach might be a better fit.
Your time horizon should also influence your choice between an active and passive investing strategy. If you're still young, mixing both an active and passive approach may allow you to benefit from the advantages of both methods.
If you follow a buy-and-hold strategy, part of your investment portfolio could hold passively selected investments that will benefit from the power of compounding. At the same time, you can also invest in actively selected investments and explore trends or niches without jeopardizing your long-term goals.
However, if you are closer to retirement, a purely passive approach might better suit your needs. The closer you come to retirement, the less risk you should take that may set you back. Therefore, the higher-risk active investments might not be a good choice anymore.
Another point to consider is that the current market environment may impact your results. For example, an active investing strategy may yield better results when the market is volatile and experiences higher price fluctuations. On the contrary, a passive investing strategy may be a better fit when investment valuations are more uniform and less volatile.
If you decide to follow an active investment strategy, you will gain more flexibility in adjusting to the current market environment. However, you may also achieve worse performance in stable market environments. On the other hand, you won't profit in more volatile market environments but are less exposed to investment risks with a passive investing strategy.
Finally, the type of investment also impacts your decision between an active and passive investing approach. Passive investing works better for easily-traded and well-known assets, such as stocks of large companies. It is much harder to gain significant insights into these assets. Therefore, active investors don't have a significant advantage when evaluating these assets.
However, this may not be true when you plan to invest in specific niche markets, like emerging markets or small-cap stocks. These are usually less well covered by analysts as well as other investors than established markets. As a result, it is easier to gain an edge against other investors.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.