Eventually, there comes a time when every investor must make a choice: Whether to invest to achieve future economic objectives or to invest for entertainment. Unfortunately, they usually don't go hand in hand. As such, it's essential to understand the different investment strategies, including passive vs. active investing.
What Is Active Investing?
As one of the many people interested in investing, you've probably wondered, "What is active investing?" In simple terms, active investing is an investment strategy that requires a hands-on approach, usually by individual investors and active managers or similar professionals. This type of investment decision puts you at the mercy of the stock market, which is characterized by its high volatility. If you go this route, it's crucial to get investment advice and research investments using tools like Morningstar.
A simple example of active investing would be actively picking individual stocks or hedge funds to make up your portfolio. This build-it-yourself type approach is called active investing because of the amount of time and research it takes to confidently invest in a less-diversified way.
What Is Passive Investing?
What is considered passive investing? Intuitively, passive investing is an investment strategy involving larger funds and less buying and selling in general. Passively managed funds are a long-term approach to building wealth by purchasing securities that use stock large market indexes as a benchmark. Rather than investing in individual stocks that have a higher risk of volatility amid fluctuations in the stock market, your investment decisions revolve around low-risk options that aren't impacted as much by market conditions because they are designed around the concept of diversification and the belief that overall, markets tend to go up. Fund managers and portfolio managers create funds designed for performance that meets the risk tolerance of an individual investor, but generally these funds lean toward the outperformance of the stock market, whether in bull or bear markets, over time.
What is an example of passive investing? Buying index funds, exchange-traded funds (ETFs), or other mutual funds.
What Is the Difference Between Active and Passive Investing?
Active investors believe that there's a constantly changing set of investment opportunities that skillful investment managers can exploit. These active managers buy and sell securities, "actively" attempting to use these opportunities. These activities are generally referred to as market timing or stock picking. Market timing involves making investment decisions based on past performance and market conditions to predict future results. If this is sounding appealing, keep in mind that you'll need a brokerage account, which typically includes higher fees.
Passive investors don't attempt to "bet" on individual stocks or narrow industry sectors to outpace the market. Instead, they try to replicate the investment results of a target index by holding all or a representative sample of the securities in the index. Thus, a passive investment approach emphasizes broad diversification, low turnover, and market returns. In addition, passive strategies have lower costs associated with them due to low fees.
Should You Pick an Active Fund or Investing Style?
If your purpose is to invest for pleasure and entertainment, then you have a legitimate reason to pursue actively managed funds. An active investment strategy is much more entertaining than passive investing because you'll have big winners and losers. You'll have many interesting reasons for investing in this or that based on significant time pouring over things like earnings reports and quarterly or annual strategy releases. You'll discuss market forecasts and hot stocks at cocktail parties and other social events. In short, you'll really be "into" the market.
However, the problem with this scenario is that you'll probably lose money. Not because you aren't smart enough to do it or don't have the chops, but because by far most investors trying to game the system do. It's simple evidence gained over decades of market history.
Even if you have aggressive financial goals, passive investing is a clear choice because of it's stability. Passive investing shouldn't be considered a "hot" or short-term investment strategy. Its main appeal isn't to investors who expect to make a "killing" in the market. Instead, this low-cost strategy should attract long-term investors who seek market-type returns through broadly diversified portfolios.
Final Thoughts on the Active vs. Passive Debate
Don't let the name fool you. When individuals are asked between an active or passive investing style, many will jump to say active. It sounds like you're taking an active approach in your investing plan and common wisdom implies that will benefit you. The reality is passive could in many ways be re-named a calm or steady investing. Just because your investment style is passive, doesn't mean you aren't still actively building your path to financial freedom in the long run.
If you ask investors and wealth managers which is better when it comes to passive investing vs. active investing, you'll get a wide range of answers. That's because in theory active and passive investing are two approaches you can take to buy assets that are expected.
You can choose many different types of investment strategies to diversify your portfolio. However, it's to your advantage to focus on ways to maximize returns while minimizing cost and risks. Consider trying to meet your financial goals through these three strategies: value investing, growth investing, or income investing. You can learn about value vs. growth investing to determine which one is right for you. Often, your approach will depend on the stage of life you're in, so take some time to explore the various ways you can invest by age.
Plancorp has a Wealth Management team of financial advisors, planners, and consultants with first-hand knowledge of active vs. passive investing and other strategies. You can download our free guide to learn how to pursue a better investment experience.