Active vs. Passive Investing
Investing isn’t a one-size-fits-all endeavor. You can choose the types of investments you want to hold and how you’d like to manage your portfolio. One significant decision you’ll need to make is whether you want to follow an active or a passive investment strategy.
Active investing involves a willingness to buy and sell often and intervene to make portfolio changes on short notice. Active investors frequently hold investments for relatively brief periods, prepared to transfer into other assets to take advantage of price movements or short-term opportunities. This type of investing is generally associated with purchasing individual securities, like stocks or options, but active investors can use mutual funds or exchange-traded funds (ETFs) as well.
Passive investing (also called “buy and hold”) is much less hands-on. Passive investors look to take advantage of the market’s tendency to rise over the long-term, so their goal is to recreate market performance over time. Consequently, passive investors tend to invest in funds—particularly index funds—although you can be considered a passive investor in individual securities if you make few trades over time.
Being a passive investor doesn’t necessarily mean you’re holding largely the same investments over the course of years or decades. Your funds might change their focus or composition periodically. And if you’re invested in index funds, these are adjusted as components are added and dropped.
With both active and passive investing, you can act as a self-directed investor—meaning you make your own decisions and manage choices about the funds in your portfolio yourself—or pay an investment professional to guide your decisions and manage your portfolio for you. In either case, the funds themselves are managed by investment advisers, and the investment adviser for a particular fund can adopt an active or passive strategy for that fund.
Assessing Active vs. Passive Investing for Your Portfolio
Advantages of active investing can include:
- Flexibility: Active investors (or managers) can typically act quickly to take advantage of short-term market trends or individual opportunities to enter or exit positions on short notice.
- Risk Management: Active investors can implement and adjust risk management strategies based on current and prospective future market conditions.
- Customization: Active investors can alter their portfolio composition frequently, if necessary, to meet changing conditions or evolving needs.
- Outperformance Goals: While passive investors generally seek to match market returns, active investors (or managers) aim to exceed market performance. Strong returns aren’t guaranteed, however, and your returns could vary significantly—higher or lower—from those of market indexes.
Advantages of passive investing can include:
- Lower Fees: Passive investors might have lower costs since less active management can mean fewer transaction and other fees. However, while low and zero commissions are available, all trading involves some fees, such as those related to bid-ask spreads and markups/markdowns and mutual fund sales loads. Be sure to verify the fees associated with investment products you’re considering.
- Tax Simplification: Though every individual’s circumstances are different, fewer transactions can potentially mean less complicated taxes for passive investors. Talk with a tax professional about how this might impact you.
- Removal of Emotion: Using a passive strategy can help investors avoid fear of missing out (FOMO), panic during market volatility and other emotional reactions that can cause investors to abandon sound investment principles. It can also help prevent you from making an impulse buy or bailing out of your positions during what could turn out to be temporary market increases or declines. To further support this disciplined approach, you can set up a periodic investing plan where you make regular securities purchases of fixed amounts on a set schedule.
- Diversification: Passive investors often rely on index funds, which can help with portfolio diversification and its associated benefits. Investing in a model portfolio that tracks multiple indexes is a way to achieve additional diversification.
- Periodic Rebalancing: Passive investors can schedule a date (say annually) to rebalance their portfolios to bring them back to their desired asset mix since investments don’t always move together over time.
Given that these strategies are opposites, the advantages of one tend to be disadvantages for the other. For example, the lower fees for passive investors are often matched with higher fees for active investors. While active investors have the potential opportunity to generate excess returns, passive investors must generally strive for market performance.
Whether to invest actively, passively or through some combination of the two is a decision you must make for yourself based on your goals, stage of life and risk tolerance. Whichever technique you choose, remember that all investments and investment strategies come with some risk.
Consider working with an investment professional to help you determine the best investment strategy to achieve your individual financial goals. Talk with a tax professional about how capital gains taxes could impact you.
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