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December 1, 2020
You might have some preconceived notions of what it means to be an active or passive investor. Visions of feverishly checking stock charts across three screens at 4 a.m. or lounging on your couch as your money grows by the second may be entertaining, but slightly inaccurate. Active and passive investing are investing strategies, which means they mainly involve a few major decisions upfront and a whole lot of ‘wait-and-see’ after.
The difference between active and passive investing
Active investing, as you may have guessed, requires some more involvement on the part of the investor. Specific strategies within active investing can involve making frequent trades, buying stock of specific companies, monitoring markets, and/or working with a portfolio manager. The main goal is to try to make alpha returns or ‘beat the market.’ This strategy can be expensive in terms of management fees and other expenses. Investors in active investing can fall prey to marketing and survivorship bias (companies don’t often have to report on their investments that failed, which means their brochure is full of ‘best case scenario’ results).
Passive investors use the market to their advantage. They know that historically the stock market has produced positive returns on average, so an expensive and reliable way to invest is to spread their money across many different companies and industries. While unglamorous and unexciting, passive investing is an inexpensive and proven investment strategy. If you’re still not quite sure about which investing strategy to pick, keep reading below:
Pros and cons of active investing
Investment costs might not seem like a big deal, but they add up, compounding along with your investment returns. In other words, you don’t just lose the tiny amount of fees you pay—you also lose all the growth that money might have had for years into the future.
Pros and cons of passive investing
A compromise: sub-portfolio investing
Passive and active investing are just two of many different investing strategies. Sometimes however, investors may have different goals and time horizons, and so they have the option of combining multiple strategies into their portfolio. Here’s an example:
Rita is an investor in her mid-20s who is trying to write down her financial goals and create an investment portfolio. Her goals are as follows:
For her first goal, Rita should invest in a passive, low-cost ETF. Because active investing can be risky and volatile, it is not a good match for retirement saving. Regular contributions to a 401k+solo retirement fund invested in the stock market should provide the diversification and returns she needs for retirement. For her second goal, Rita can use a mixture of passive and active investing to help pay for her sister’s college costs. If her sister is a high school junior, a majority of Rita’s savings for this goal would be in a high-yield savings account, but Rita could invest 20-30% of funds into a mutual fund. Her third goal is a ‘nice-to-have’, which means that Rita can be a bit aggressive when picking her investing strategy for the third goal. An active strategy could help Rita advance quickly toward her donation goal, but if she does not see exceptional returns in this sub-portfolio it will not substantially impact her quality of life.
Whichever investment strategy you choose, it’s important to remember the reasons you chose it during recessions and bear markets. The only ‘wrong’ investment decision is one that is made out of fear or frenzy. Writing down the reasons you chose to invest in a specific strategy is a great way to come back to the basics when you feel scared or doubt yourself.