An active vs. passive approach is one of the most contentious topics in long-term investing today. When it comes to investing, it is never a one size fits all scenario, and there are certainly always pros and cons to every approach. Our aim is to provide insight into what both strategies offer and how they differ from each other to help you make a well-informed decision. So what approach is best for you? Let’s examine the differences.
An active portfolio strategy can be managed by yourself or an investment professional. The hallmark of an active management strategy is that it requires frequent buying and selling in an effort to outperform a specific benchmark or index.
A lot of work goes into managing an active portfolio, as the belief is that success behind an actively managed portfolio depends on a hands-on approach. This method includes research and market forecasting and relies on the expertise of the individual or team that is behind an actively managed fund.
Active investing is a highly involved activity, so it is best suited to an individual who has experience in the market and also has the time and resources to actively participate in managing their portfolio. It is also a better fit for someone with a higher net worth, due to its higher cost.
Active research, analysis and higher frequency of trades are the aspects that proponents of active management strategies say will lead to higher returns, as opposed to just buying and holding stocks that are listed on an index.
Pros and Cons of Active Investing
Because active investment strategies involve ongoing buying and selling activity by the investor or fund, if an opportunity presents itself, it can be beneficial to the investor to help outpace a particular index. Active strategies allow for investors to exploit profitable opportunities because they are constantly searching for them and may be more in tune with the market.
- Potential to outperform the market or a particular index
- Positioning to exploit a profitable scenario
As most investors know, however, things do not always go as planned. Human error represents a potential drawback for an active strategy or fund. Actively managed funds also tend to have higher fees and higher minimum amount thresholds than their passive counterparts.
- Typically higher fees
- Potential to underperform the market
- Prone to human error/higher risk
A passive investment strategy is more of a hands-off approach that investors use to generate returns that mirror the returns of an underlying index. An example of a passive approach is to buy ETFs or index funds that follow one of the major indices like the Dow Jones or the S&P 500.
A passive investment strategy is more of a “set it and forget it” approach, where the investor puts their faith in the underlying index knowing that over time, these indexes deliver returns. A passive investment approach does not mean that the investor does not actively participate in their investment, however, as it is important to dollar cost average and continuously add funds and contribute to their passive portfolio.
Passive investing is best suited to beginning investors, and those who want to have regular access to their portfolio and awareness of what they are investing in.
Pros and Cons of a Passive Approach
Investing in a passive fund is typically the cheapest way to access the market, as the limited amount of human interference lends itself to lower fees and none of the commissions that come with active managers.
- Lower cost
- More tax efficient due to less transactions
- Lower risk
If you are prepared to invest over the long-haul, a passive approach tends to work best as the markets historically have delivered positive results. Passive funds are also simpler, meaning you have a good idea of where you money is invested and can move funds in and out of it relatively easily.
- Typically will not outperform the market
- Harder to alter your investments in a downturn
Because passive strategies or funds are limited to a specific index or set of predetermined investments, investors are a bit limited by a passive strategy. And since passive funds are generally aligned with particular indexes, they generally will not outperform the market.
The Bottom Line
Now that you are aware of both strategies, it may be worth considering what strategy you want to utilize throughout your investing career. Passive funds are less expensive but rarely outperform the market, while active funds are more costly and are prone to human error, but can outperform the market if conditions are favorable.
When it comes to investing, it’s best to dip your toe in any strategy before you fully commit to something if you are unsure if it is the right fit.