It’s a common debate in the investment world. Which is better—active or passive investing?
If you have a competitive streak or a high tolerance for risk, opting for an active investment strategy may be tempting.
It offers you a chance to beat the market and brag to anyone who will listen if you (or your fund manager) pick the stock that outperforms the market.
However, a passive strategy will typically serve you better if you’re investing for the long haul. It may not be flashy or exciting, but it’s a strategy you can take to the bank…literally.
Why?
It’s nearly impossible to beat the market consistently over the long term. However, it is possible to harness consistent market growth, over time, which is what passive investing is about.
Historically, that would mean earning an average annual return of nearly 10% if you invested in the U.S. stock market.
Read on to learn about the differences between active and passive investing, the pros and cons of each and which one may be right for you.
What is Active Investing?
Active investors try to beat the market by predicting which investments will outperform the market average and including them in their portfolio while excluding those they think will underperform.
They attempt to buy low and sell high, which sounds great and makes investors feel like they have more control over their portfolio’s performance. After all, who wouldn’t want to earn more than the average?
The problem is that beating the market is a “zero-sum” game before you factor in the additional costs associated with active management (more on that in a bit).
For every investor who “wins” and outperforms the market average, there must be an investor who “loses” and performs below the average.
So how likely are you to win consistently?
Not very, according to the S&P Indices Versus Active (SPIVA) Scorecard, which has served as a de facto measure of the effectiveness of active vs. passive management since 2002.
Even if a fund beats the market one year, history suggests the likelihood that the same fund will continue performing above the market average decreases with each passing year because it’s nearly impossible to consistently predict which investments will beat the market.
To accurately predict the future value of investments, you would need to have better information than the market overall. Add to that the costs of active management, and it’s tough to come out ahead.
Take U.S. domestic funds as an example. In 2020, 43% of all U.S. domestic funds outperformed their benchmark, but by 2023, that number dropped to 25%, and over the last 20 years, only 6% of U.S. domestic funds performed above the benchmark.
What is Passive Investing?
Passive investing doesn’t attempt to predict which investments will outperform the average. It aims to capture the long-term appreciation of the market while reducing costs and minimizing the additional risk associated with investing in individual stocks or specific market sectors.
Passive investors don’t try to time the market or cherry-pick funds.
They invest in passively managed funds that represent the make-up of the stock market or a subset of it. As a result, the performance of a passively managed portfolio is almost identical to the performance of the market.
Its effectiveness lies in its simplicity.
Over the last 100 years, U.S. stock market returns have averaged approximately 10% annually. Some years, the market performed better; in others, it performed worse.
But if you had invested for the long term during that time, you could expect to earn an average return of 10% per year.
Examples of Passive Funds
Most exchange-traded funds (ETFs) are passive funds that track to a market index, such as the S&P 500 Index, NASDAQ Composite Index or Dow Industrial Jones Average.
They include hundreds of different stocks—each weighted based on the overall composition of the U.S. stock market.
Key Differences Between Active and Passive Investing
The main difference between active and passive investing is that active management tries to outperform the market average, and passive investing aims to capture the long-term appreciation of the market.
Because of the research active investing requires, including trading costs and taxes generated from frequent buying and selling, active investing typically has higher total costs than passive investing, reducing net returns.
It’s also riskier.
There’s an inherent risk to investing in the stock market, which correlates to expected returns. Those risks include economic changes, political events, interest rate fluctuations and more.
Individual investors are compensated for the risk with a higher expected return compared to more conservative options like investing in a high-yield savings account. This is known as “market” or “systematic” risk. Market risk exists whether an investor engages in an active or passive investment strategy.
However, if you opt for an actively managed strategy, you are taking on additional risk.
Theoretically, you do this in exchange for a better return, but historical data shows that’s not what happens.
Here’s why.
Investing in a single stock or small concentration of stocks adds “specific” risk—beyond what you’d assume simply by investing in the stock market—without a corresponding increase in expected return.
For example, a single stock is subject to potential volatility a company may experience due to a specific event, such as unpredictable event, an erratic action or decision by an executive or the board or having an unpopular position on a social issue that results in significant media attention.
This additional risk doesn’t result in a premium on the expected return compared to buying stocks aggregated in an index-like fund.
On the flip side, investing in a diversified portfolio minimizes the “specific” risk you take on. It limits your portfolio to the “market” risk all investors assume and are appropriately compensated for when you consider the long-term appreciation of the market.
Pros and Cons of Active Investing
Before deciding which investment strategy is right for you, consider the potential benefits and drawbacks of active investing.
Pros:
- You have an opportunity to beat the market. In any given year, some stocks and actively-managed funds will outperform the market average.
Cons:
- It has higher total costs. Research costs, trading costs and taxes increase fees for actively managed funds.
- It’s nearly impossible to time the market. Markets are complex, adaptive systems, making it difficult to consistently time their movements. An investor must time the market right twice—when buying and when selling—to “beat” the market.
- The winners don’t keep winning. Over long periods of time, your chances of continually outperforming the market decrease.
Pros and Cons of Passive Investing
Here’s what you need to know about the pros and cons of passive investing.
Pros:
- It costs less. Passive investment management typically has fewer trading and research costs and lower taxes.
- It’s tax-efficient. Investing isn’t just about how much you earn; it’s about how much you get to keep. Since the securities in passive funds aren’t actively traded, and you’re holding onto them for the long term, you benefit from the tax advantages of long-term capital gains tax rates.
- It has less volatility. Diversified portfolios are subject to market risk but minimize the additional volatility associated with active management.
Cons:
- You won’t get rich quick. If you’re looking for a shortcut to get ahead overnight, passive investing is not the solution. Passive investing builds wealth with the power of compound growth of the broad markets and economy over the long-term.
Which Investing Strategy to Choose
Individual investors should expect market volatility—no matter what investment strategy they use. If you want to invest, you should be prepared to do it for the long term.
If you like the idea of chasing returns, want to try to beat the market and are comfortable with the additional risk and costs associated with it, active investing is your best bet.
However, passive or evidence-based investing makes sense for long-term investors who want an effective strategy for building wealth over their lifetime.
Evidence-based investing is a unique subset of passive investing that we, at Plancorp, recommend to many of our clients. It combines the long-term market growth of a passive strategy with research that guides how you allocate your portfolio.
Evidence-based investing has three main principles:
- It’s academic data driven. This type of investing is based on peer-reviewed academic research of historical market performance.
- It’s time-tested. Evidence-based investing involves strategies that have been shown to work for the last 50+ years.
- It’s based on robust analysis. Decades of research have identified patterns and behaviors that repeat themselves and are more likely to be successful.
Evidence-based investing isn’t about trying to predict what will happen next.
It’s about making informed decisions about asset allocation based on the probability of a particular outcome and sticking with that investment strategy for the long term.
Is it Time to Get an RIA on Your Team?
Not sure which investment strategy is right for you?
A financial advisor can create a comprehensive wealth management plan tailored to your unique investment goals.
At Plancorp, we develop your financial plan together and make informed investment and asset allocation decisions that align with your financial objectives, risk tolerance and investment timeline.
While markets have long-term expected returns, it’s important to understand that “risk” means there will be market downturns.
Having an investment strategy in place that’s supported by comprehensive financial planning is critical to staying the course and avoiding emotional decision-making during inevitable market volatility and declines.
To determine if your financial plan could benefit from a conversation with a financial advisor, check out our two-minute financial analysis and get personalized feedback based on your answers.
