Being a passive investor means that you invest for the longer term. Passive investing means you limit the amount of buying and selling going on in your portfolio and that makes this approach a very cost-effective way to invest.
With this strategy, you must have a buy-and-hold mentality, which means resisting temptations to react or anticipate every move of the stock market.
Passive investing also involves buying an index fund that tracks one of the major indexes in the market. Whenever these indexes switch up their components, the index funds automatically switch up their holdings by selling the stocks that are being left out and buying the stocks that are going to be a part of the index.
Active investing, on the other hand, takes a more hands-on approach and requires that a person act as a portfolio manager. The goal of active investing is to beat the stock market’s average returns and take full advantage of short-term price fluctuations.
This involves a much deeper research and expertise in order to know when to switch into or out of a stock, bond, or any other asset. A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors, then try to predict where and when the price will change.
Which strategy will you choose?
It’s quite easy to imagine that a professional portfolio manager would beat a basic index fund. However, that’s not always the case.
If we look at superficial performance results, passive investing works best for most of the investing populace. Researches conducted over decades show disappointing outcomes for the active investors. As a matter of fact, only a small percentage of actively managed mutual funds ever outperform passive index funds.
However, all this evidence showing passive beats active may be an oversimplification of something that’s more complex. This is because both active and passive investing exist for a good reason and many successful and professionals use a combination of both strategies.
Benefits and Risks
Passive investing
Some of the major benefits of passive investing include:
- Super low fees – there’s no one selecting stocks, so the management is much less expensive. Passively managed funds merely follow the indexes that they use as their benchmark.
- Transparency – it’s always clear and obvious which assets are included in index funds.
- Tax efficient – the buy-and-hold strategy doesn’t usually lead to a massive capital gains tax for a year.
Meanwhile, critics of passive investing believe that the following are the main weaknesses of this strategy:
- Limitations – passive funds are limited to a specific index or predetermined set of investments with little to no variance.
- Small returns – obviously, passive investing will never let you beat the market even in times of turmoil since their core holdings are only there to track the broader market.
Active Investing
The following are the main advantages of active investing
- Flexibility – active managers are not required to follow any specific strategy.
- Hedging – active managers can also use different techniques like shorting or put options, enabling them to ditch specific stocks or assets when the risks become too big.
Meanwhile, active strategies have the following risks:
- Expensive – The average expense ratio for an actively managed equity fund falls at 1.4 percent. Compare that to only 0.6 percent for the average passive equity fund.
- Active Risks – active managers are free to by any kind of investments that they think would bring them high returns. This is great when they hit the spot, but disastrous when they’re wrong.