When it comes to investing, there are two schools of thought – active investing and passive investing. You will find that many people are of the belief that one or the other of these schools of thought is the way to invest. If you are new to investing, you probably have no clue what the difference is between active investing and passive investing. Furthermore, you might question if it even matters. For example, is one better than the other, or is it simply a preference like boxers or briefs, jam or jelly?
While it would be nice if it were simply a preference, in reality one of these investing strategies is actually a smarter move for you to make with your money. I’ll get into the details later, but for now, let’s start off making sure we understand what each strategy believes in.
Passive Investing & Active Investing Defined
Time to talk about what each of these strategies are. I’ll give a basic definition and then get into more detail below.
Passive Investing: Passive investing involves either buying investments that track an underlying index or creating an asset allocation and sticking to it for the long term.
For example, investing in a mutual fund or ETF that tracks the S&P 500 Index is a form of passive investing. If you put your money into the Vanguard 500 Fund (VFINX), you are investing passively. This is because the mutual fund’s goal is to simply return what the S&P 500 returns every year.
Another form of passive investing is setting an asset allocation and sticking with it for the long term. For example, if you were to pick an allocation of 60% stocks and 40% bonds, you stick with this allocation regardless if the market is rising or falling.
Active Investing: Active investing involves ongoing buying and selling actions by an investor. Active investors purchase investments and continuously monitor their activity in order to exploit profitable conditions. It also can mean changing your allocation based on what the market is doing.
For example, in terms of buying and selling, you are looking to make a short term profit on the price swings of a stock. You actively are trading investments either daily or weekly in an attempt to maximize profits.
Another form of active investing is changing your asset allocation. For example, you might have a portfolio made up of 60% stocks and 40% bonds, but fear a recession coming. As a result, you reduce your stock exposure to 40% and increase your bond holdings to 60%.
Now that we know the differences between the two, which strategy is the better long term option for your investment dollars?
Active Investing vs. Passive Investing Showdown
As with anything in life, there are advantages and disadvantages to both active and passive investing. I won’t go through the entire list as some of them can get fairly technical. Instead I will keep it basic and only cover the most important points for both.
Active Investing Advantages
- Potential For Higher Return: since active investing involves the buying and selling of investments, you can potentially outperform the market if you are able to find some gems out there and make the right trade at the right time.
- Professional Management: active mutual funds are run by a team of managers that oversee the funds and make decisions when to buy and sell. Since they are educated in finance, they have a higher probability (in theory) of beating the market.
- Able To Play Defense: when the market turns south, a manager of an active fund is able to play defense to some extent. This means they can sell off some more risky investments and instead invest in more safe holdings.
Active Investing Disadvantages
- Typical Below Average Return: while I noted above that the managers are educated in finance, they should be able to beat the market. Unfortunately they don’t. In fact, it is very rare for a manager to consistently beat the market. They may do so here and there, but not every year.
- High Fees: because of professional management, active funds tend to have higher fees since you are paying for the professional management. This eats into your returns over the years.
Passive Investing Advantages
- Low Cost: passive funds don’t have professional managers that need to pay attention to the market and make trades and modify holdings on a regular basis. They simply invest as the underlying index is set up. Therefore, the fees are much lower, which pays off in the long run.
- Get What The Market Gives: you are never earning less than what the market returns when you invest passively. You are always going to get what the market returns, be that good or bad.
- Simple: passive investing is simple. You pick an allocation and some investments and you are pretty much done. You don’t have to monitor the market daily to make any changes or try to take advantage of price swings.
Passive Investing Disadvantages
- Never Beat The Market: while a benefit is always earning what the market does, you never beat the market. To some, this is an issue, but if the market returns on average 8% annually over the years, that is a pretty good return.
- Lack Of Action: when the market drops, you are stuck with your allocation and investments since you aren’t trading based on what the market is doing.
There are two common misconceptions that most investors have when it comes to active and passive investing.
For active investing, many investors assume that the higher fee they pay means better performance. After all, we’ve been told all of our lives that you get what you pay for. So, this must be true too. Unfortunately it’s not.
As I noted above, most professional fund managers can’t beat the market on a regular basis. So why pay them more for mediocre performance? Don’t make the mistake of thinking paying more for your investments means better performance or a higher return. It doesn’t work that way.
For passive investing, many investors assume once you set up your portfolio you are done and never touch things again. This is wrong. You still monitor your portfolio and make adjustments as the market moves. This is called rebalancing.
When stocks rise in value, bonds tend to fall. So your 60% stock, 40% bond portfolio is now a 70% stock, 30% bond portfolio. You need to make adjustments to get it back in line. While passive investing has much less work, there is still some monitoring that needs to be done.
So Which Strategy Is Better Long Term?
Over the long term, hands down passive investing is the better choice. The fees you pay are lower and you are always getting what the market returns. You never underperform the market.
While it is true you don’t take a more defensive stand when the markets drop, consider this: most investors can’t time the market anyway. They sell too late after a drop and they buy in too late after the rise.
In fact, as I pointed out above, even professionals cannot beat the market consistently. They can do it for a year or two, but always revert back to the mean and underperform. So why bother chasing returns of active investing when you can make your life that much easier by investing passively?
Interestingly enough, you will find studies talking about the benefits of active investing. Sadly these studies are all funded by Wall Street. All of the independent studies done on the subject conclude that passive investing is the smarter choice.
And why does Wall Street want you to invest actively? Money! It’s all about the money. The more you trade, the more they make in trading fees and commissions. Even if you are in a mutual fund and aren’t doing the trading, the fund manager is and is paying fees. And don’t think for a second those fees aren’t passed on to you.
So why do many investors choose active management? It is the sexier choice. People want to talk about how their investment grew 20% last year. No one wants to hear about passive investing. It isn’t glamorous. It’s very boring. But just like the fable of the tortoise and the hare, the winner isn’t the sexier choice.
Invest in passively managed mutual funds or ETFs that track the market. (I personally recommend Betterment.) It isn’t sexy or glamorous. It’s investing. Invest your money in a handful of well run passive mutual funds or ETFs, add money on a regular basis and forget about them. Go do something else with your time.
Ignore the media and the doom and gloom when the markets drop. Ignore the hype when your mechanic tells you of a fund that he earned 50% in last year. Simply invest in the market and earn the market return. It sounds easy and it is.
The hard part is ignoring your emotions and not acting on them. But if you can learn to do this, you will come out miles ahead of other investors who are greedy, hoping to beat the market.
But if after reading this you have to try to beat the market, do yourself a favor and make sure you understand the fees you are paying. Try to find the investments that are performing the best and have the lowest fees. You can track the fees you pay for free using Personal Capital. If you decide to try to beat the market with stocks, Motif Investing is a great choice that will at least save you money on your trading fees.
Just make sure you are with a broker that meets your needs and offers what you are looking for. You can find the best broker for you in this comparison chart.
If you want to learn the basics when it comes to investing and be a successful investor, I suggest you read my ebook, 7 Investing Steps That Will Make You Wealthy which you can find on my resources page.