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Active vs Passive Investing


Summary

  • Active investing is a hands-on DIY approach to investing that is time and labor intensive
  • Passive investing utilizes a buy and hold approach to weather the storm even when the market takes a plunge
  • Both are valid forms of investing and you can choose which type you want to be, or blend the two approaches

Introduction

There are two ways to approach investing: through active investing or passive investing, or a mix of both. The debate over which is “better” is ongoing—and for good reason. Before diving into the differentiation between the two, it’s important to know the distinctions that make them unique. Knowing how they compare could be the difference in creating a profitable portfolio for your lifestyle. 

What is Active Investing?

Active investing is being very involved in your investment strategy. You’re not checking your portfolio every 2 weeks- you’re checking it every single day. It’s very involved. It is the constant act of buying and selling securities. There is a lot of research that goes into the active investor and what their goal is. An active investor falls into the category of a “day trader” and may make many trades in one day. These types of investors seek profits daily and test their skill and research in order to gain profit. An active investor steadily is watching markets, and expanding their knowledge as they follow the news. Given that the goal of the investor is to gain profits, they need to ensure that they are on top of trade news and how companies are performing. For example, mergers and acquisitions can sway the market in a day, and following the events leading up to a huge merger is what many day traders profit off of. There is literally limitless potential in knowing what the sale of a company could mean for another company. The active investor is very hands-on and will try to beat the market day after day. This could mean that you or your portfolio manager may try to beat the returns of the S&P 500.

The thrill of the market is also what gets active investors into trouble. Though investing in a savings account is a sure bet, your gains will be minimal given the extremely low-interest rates. But don’t forgo one completely. A savings account is a reliable place for an emergency fund, whereas a market investment is not.

“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.” — Robert G. Allen

What is Passive Investing?

Now that we know about the active investor let’s talk about the passive investor. If you’re a passive investor you think long-term. You’re not trying to “beat the market” but rather match the performance of different indexes. The whole day trading, quick profits, and hands on approach isn’t for you. The passive investor is holding in order to gain long term capital and limiting their buying and selling within the market. This can be a very hard thing to do when the economy is unstable or there is a sudden market downturn. Holding onto a stock that is “tanking” is not easy, however it can pay off in the long term. It’s also less expensive to be a passive investor, as over time the constant trading fees of the active investor can add up. Not only that but active investing can be risky, and incorrect recommendations from analysts could destroy one’s portfolio. Although allocating large sums of money into a fund or stock that takes a nosedive is a risk that any investor may make, the risk is really something that active investors encounter more.

By and far, the buy and hold strategy of passive investing is more cost-effective. When the price of the securities goes up over time, so does your portfolio. The returns can be much greater through the buy and hold strategy. That is why passive investing is more common and a safer way to invest your money.

So which one is better? Active and passive investing have their strengths and weaknesses. For example with active investing the fees can truly add up. Paying portfolio managers and various research analysts isn’t an affordable way to do business. On the other hand, passive investing requires immense discipline in regards to holding through ups and downs through the markets. 

Perhaps the best strategy is one that involves both active and passive investing. Getting a taste of both worlds may work out in the long run. This debate will keep going on until the end of time. Truly at the end of the day it depends on your goals, timeline and sought after return numbers. 

Active vs Passive Investing

Quick Quiz

Review and answer these two questions to move on to the next section in the course.

What is the #1 mistake investors make when choosing what to invest in?

Wrong answer, please select correct one.

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Wrong answer, please select correct one.

What is a goal of active investing?

Wrong answer, please select correct one.

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Wrong answer, please select correct one.