Active Investing vs. Passive Investing

As an investor, you need to decide how you will allocate your portfolio as well as what kind of investing philosophy you wish to follow. You need to determine how much of your individual judgment you want to use for building your portfolio, compared to going with the overall flow of the market. That is where active and passive investing styles come into play.

Passive investors choose to go with the market and merely attempt to replicate the market’s returns. In contrast, active investors will try to design portfolios and investment strategies based on their beliefs about certain sections of the market, with the goal of achieving market-returns with less risk and volatility or even trying to beat the market’s average returns.

What is the difference?

As a passive investor, you will buy an index fund that tracks the market as a whole. Your returns will be equal to the stock market’s overall returns, so you will only perform only as well as the overall market.

As an active investor, you instead choose in which slice of the market to invest. You build your own portfolio with different allocations for various stocks and other assets. Active investing is normally what people call “investing” in general.

The two styles differ primarily in the kind of exposure their portfolios will have compared to the overall market. With this, comes different levels of investment risk.

What pros and cons should I consider?

Passive: save time and reduce risk, but forgo choice.

As a passive investor, you significantly reduce the amount of time you need to spend managing your portfolio. Furthermore, you reduce the risk of making bad investments that end up producing lower returns than the market average.

However, as a passive investor, you also lose out on the opportunity to invest in particularly appealing companies, sectors, or assets. Also, the market does not always provide good returns on average, as if one were to invest in the middle of a bear-market one’s returns would then be poor.

Active: more control comes with increased risks and time.

As an active investor you have more control over the kind of investments you can make, and therefore have the possibility of achieving above-market returns. Also, being an active investor allows you to tailor your portfolio depending on your specific risk-tolerance and income needs, as compared to replicating the entire equity market.

Drawbacks of active investing include making poor investment decisions or allocations that may result in below market returns. Furthermore active investing can take a significant amount of time in order to do research on companies and sectors, as well as in monitoring and balancing your portfolio.

How do I choose what is best for me?

As an investor, you should look at your individual time commitment, investment knowledge, risk-tolerance and income goals in determining whether to be a passive or active investor.

For investors who wish to have a more hands-off approach, whether due to time commitments or lack of financial knowledge, passive investing is a simple yet effective way to invest. It requires little time, either for buying, monitoring, or selling, and also lowers the risk of making bad investment decisions.

Active investing is an option for those who believe they are knowledgeable enough about the market, as well as have the time and energy, to make better investments than the overall market.

How do funds play into this?

As a passive investor, you will not be able to directly “buy the market”. Instead, you will have to choose an investment fund that replicates the market or a large portion of it, and invest your money there.

There are a variety of funds out there for passive investors that only seek to replicate a major market index, such as the NASDAQ, S&P 500, or Russell 2000. For passive investors, this is the best way to invest.

For active investors, funds can also serve an extremely useful function. There are a variety of mutual funds and ETFs out there that allow investors to customize their investment strategies and asset allocations to suit their needs.

Investing is something that a financial advisor can do on your behalf. They are skilled in investment management and will almost always offer this service as part of your holistic financial plan. Financial advisors will charge a fee for this service, and the many of the best will also work in a fiduciary capacity – have a look here for more details on how advisors charge.