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Active vs. Passive Investing

Chances are, if you put a group of Bogleheads in a room with a bunch of fund managers, it’s likely nobody will completely agree on the best investing approach. If you casually toss the active vs. passive debate toward that crowd, it could turn up the heat and pave the way for some serious argument.

Maybe the famous economist Burton Malkiel said it best: “A blindfolded monkey throwing darts at the stock listings could select a portfolio just as well as one selected by the experts,” which makes an excellent case for passive investing.

Or maybe there’s real value in hiring a hedge fund manager, as it’s true that there’s nothing sexy about letting your investments sit… and sit some more. If you’re in pursuit of large, quick returns, you’ll likely never get on board with passive investing; therefore, active investing might always make sense for you.

Two types of investing

Active investing is an investment strategy in which a manager, or you, as an active investor, purchase investments with the goal of taking advantage of profitable conditions in the market to “beat the market”.

On the other hand, passive investing is, in many ways, the exact opposite. It’s an investment strategy that avoids the fees that occur from frequent trading, and investors who use this strategy keep these types of investments for the long haul. Passive investors do not actively buy and sell their investments as prices change in the market.

Examples of active and passive investing

Passive investing includes:

  • Real estate: Real estate is clearly a matter of passive investing. Invest in a property, get some decent renters, and watch the money roll in. (Theoretically, that’s the way it works, anyway.)

  • Stocks: Dividend-paying stocks, that is. This is a great way to invest because the money comes in in the form of dividends. You’re not actively trading, you’re not looking to sell… you’re in it for the long haul, and as long as you can see the growth potential of certain companies, you’ll be on your way to a great source of passive income.

  • Index funds: Vanguard’s website describes index funds really well. Instead of hiring fund managers to actively select which stocks or bonds the fund will hold, an index fund buys all (or a representative sample) of the securities in a specific index, like the S&P 500 Index. The goal of an index fund is to track the performance of a specific market benchmark as closely as possible. That’s why you may hear it referred to as a “passively managed” fund.

  • Peer-to-peer lending: Cheaper and faster than any bank, peer-to-peer lending allows individuals to borrow without having to involve an institution like a bank or credit union. As an investor, you’ll see some major advantages and differences in the different types of loans you can invest in, so it’s important to do your research.

Active investing includes:

  • Stock picking: Investors or fund managers buy equities which are considered undervalued, and have potential to increase in price or pay increased dividends over time. The tricky thing is that there is no “one way” to pick stocks; it’s just a matter of determining which stocks you believe are priced lowest. Note: stock pickers who sit on a stock can be considered just as passive as those who buy index funds. For true stock picking within active investing, you’ll buy and sell often.

  • Active investing in mutual funds: Professional mutual fund managers charge an annual fee, use the money to do research and pick a basket of stocks to try and beat the market. 
  • Active investing by hedge funds: This method is generally for high net worth individuals and institutions. Hedge fund managers differentiate themselves from mutual funds by going short at times to potentially deliver high risk-adjusted returns. Due to having more resources, the bigger hedge funds may also do more research on specific companies.

The arguments for passive and active investing

A 2016 study by S&P Dow Jones Indices indicated that about 90 percent of active stock managers failed to beat their index targets. John Bogle, founder of Vanguard, noticed active mutual funds charge higher fees, so their performance performed worse than the index. The presence of fees is one of the most powerful reasons to invest in passive index funds. (Low-cost S&P 500 index funds have also been heavily endorsed by Warren Buffett.)

However, if you stick to passive funds (in particular, those that track an index) those may not coincide with the outcomes you’re seeking. Again, always consider your goals. Active investing really could be better, depending on your personal situation.

How do I know which method makes sense for me?

Three things matter if you’re trying to decide between active and passive investing:

  1. Time horizon (define how much time you have/want to invest),

  2. Risk tolerance, and

  3. Financial goals

If you need the money in 20 years, have a fairly low risk tolerance and your financial goals are relaxed, then you may be a prime candidate for holding passive funds. On the other hand, you’ll be comfortable with active funds if you have high risk tolerance and an instinct for immediate financial goals.

Final thoughts

If you’d like to dive into active investments but don’t have the the time or skills to do it all by yourself, you’ll want to pick a mutual fund or hedge fund with lower fees and a solid track record. While it’s true that past performance does not predict future returns, a record of success may indicate a solid research strategy and highlight companies which have a good handle on risk.

If you’re a do-it-yourselfer and you’d also like to go the active investments route and are more risk tolerant, buy a basket of riskier securities, such as tech stocks, growth stocks, and small caps. Although the securities are riskier and more volatile, they could potentially deliver higher returns in the long run.

If you’re a passive investor, you’ll likely have a few more diverse options open to you, as mentioned above. Peer-to-peer lending, real estate, index funds, dividend stocks: All, however, require some research. Just like you’d never want to buy a rental property in an area of your city you’ve never investigated, you also wouldn’t want to buy an index fund without properly researching the fund.