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 expert portfolio managers,” 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 make more sense for you.

What is Active 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 stock market to beat the market.

Pros

• Ability to take advantage of market opportunities and make quick adjustments to investment strategies
• Actively manage portfolios and make decisions based on your own research and analysis
• Greater flexibility and customization in investment choices

Cons

• Requires a significant amount of time and effort for research, monitoring and decision-making
• Higher costs associated with active investing, including transaction fees and management fees
• Prone to emotional biases and making impulsive investment decisions

What is Passive Investing?

Passive investing follows the opposite path. 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.

Pros

• Lower fees and expenses compared to actively managed funds
• Less time and effort for research and monitoring
• Typically delivers consistent returns over the long term

Cons

• Lack of flexibility to react to market changes
• Susceptible to market downturns and volatility
• Reliance on the overall market performance for returns

The Difference Between Active and Passive Investing

Here are the key differences between active vs. passive investing.

Passive Investments

Real Estate

Real estate is an example of passive investing. Theoretically, you invest in a property, get some decent renters and watch the money roll in. It doesn’t always work that way, but that’s the premise of this passive investment.

Stocks

Dividend-paying stocks, that is. This is a great way to invest because the money comes 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 could be on your way to a great source of passive income.

Index Funds

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. The goal of an index fund is to track the performance of a specific market index 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 a 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 advantages and differences in the different types of loans you can invest in, so it’s important to do your research.

Active Investments

Stock Picking

Investors or fund managers buy equities that are considered undervalued and have the potential to increase in price or pay higher dividends over time. The tricky thing is that there is no one right way to pick stocks; it’s a matter of determining which stocks you believe are priced lowest. 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. Because they have more resources, bigger hedge funds may also do more research on specific companies.

The Argument for Active and Passive Investing

A 2016 study by S&P Dow Jones Indices indicated that about 90 percent of active stock investment managers failed to beat their index targets.

John Bogle, founder of Vanguard, noticed that active mutual funds charge higher fees and perform worse than the index. The presence of fees in actively managed funds 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. Consider your goals. Active investing could be better, depending on your personal situation.

Active vs. Passive Investing: Which is Best for You?

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

• Time horizon
• Risk tolerance
• 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 may be more comfortable with active funds if you have high-risk tolerance and an instinct for immediate financial goals.

Proper Research is Key

If you’d like to dive into active investing but don’t have the time or skills to do it by yourself, you could pick a mutual fund or ETF 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 that have a good handle on risk.

If you’re a risk-tolerant do-it-yourselfer and you’d also like to go the active investments route, you could buy and actively manage a basket of riskier securities, such as tech stocks, growth stocks and small caps.

Although tech 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, including peer-to-peer lending, real estate, index funds or dividend stocks. These investments require some research.

Just like you wouldn’t want to buy a rental property in an area of your city you’ve never investigated, you’d also avoid buying an index fund without properly researching the fund.

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Frequently Asked Questions