If you listen to analysts, brokers, or traders, you'll hear thousands of theories and philosophies on proper methods of investment. The two broadest categories that encapsulate most of them are active investing and passive investing.
What Is Active Investing?
In essence, active investing is a hands-on approach. You invest in securities and watch them. You monitor them after buying them, and you actively pursue actions that will take advantage of market conditions.
An active investor very much believes that they can outperform the market by capitalizing on price movements, events, and conditions. A prime example might be investing in Gilead Sciences two months ahead of earnings on a dip because you believe that a new pharmaceutical drug will lead to sales growth. Once the earnings are released, you sell the peak.
Another example might be investing in an actively managed fund, where the portfolio managers choose stocks actively, monitoring events and making moves. This differs from buying an index fund that largely follows the market. Many mutual funds operate in this fashion, and some exchange-traded funds do as well, although usually to a lesser extent.
What Is Passive Investing?
Passive investing is more of what you might imagine Warren Buffet does. Passive investment involves researching a stock, fund, or ETF and then investing in its long-term potential. You essentially "buy and hold" stocks that you think are priced below their intrinsic value based on their fundamentals.
A passive investor doesn't worry about capitalizing on the short term or a particular event, and rather holds faith in the long-term potential of an investment over a greater period of time. A passive investment strategy operates under the assumption that the efficiency of the market over the long term can and will yield the best results.
Active Investing vs. Passive Investing: What Are the Differences?
The differences here are pretty clear-cut. Active investing involves actively paying attention to the market and your investments. If something happens that either creates incentives to add more shares to your position (or sell shares), you do it.
Active investment has no problem with short-term gains. That's not necessarily to say that an active investor can't take a long position, but the strategy usually would cause someone to move their positions around more often than a passive investment strategy.
Passive investors do not check their positions daily. If they buy 1,000 shares of Ford, they sit on that big dividend and let the position develop over time with the market.
An active investment strategy in Ford, on the other hand, might include the trimming or increasing of positions on events like "strong July truck sales" or things of that nature.
Return Potential
Active investment definitely creates the opportunity for higher returns. By reacting to events and developments, one can take advantage of situations in order to increase returns and/or avert broader market pullbacks.
This is why active asset managers within areas like mutual funds and hedge funds have been able to outperform the market at different points in time. However, for every active investor that beats the market, there are probably 10 that underperform.
Success is not guaranteed, and it's not an easy game. If it were, there would be a great many more billionaire investors. If your instincts are wrong on a short-term position, you can lose a great deal of money quickly.
If you sell too early because of a sudden price jump, you might miss out on the 30% expansion that occurs over the next 12 months. On a fund or portfolio level, the lack of ties with indexing creates the chance for you to both beat the market and underperform it.
Passive investment limits your potential for big returns. By buying and holding, you are operating at the pace of the marketplace, whether in reference to a single security or a fund. Most people invest in funds rather than individual stocks or bonds. These funds are usually pegged to an index that tracks a sector or industry. The costs and structures vary a bit, but that's the general idea.
When you buy these passive funds, you know what the holdings are, and you are in for the ride with that grouping as it trades within the market. That said, because these funds are pegged to indexes within the market, they substantially decrease the risks of underperforming benchmarks. It is very much by chance if a passive strategy fund beats the marketplace by much.
You might make the counter that "Buffett does it." That's true, but most of his big gains were made by purchasing entire or massive chunks of companies, using negotiated preferred shares, with different dividends. He also purchases actual companies rather than indexes.
Costs and Headaches
Active investment strategies definitely cost more in terms of transactions. On an individual level, the constant buying and selling will run up your fees for transactions. On a fund level, investing in actively managed funds increases costs associated with the portfolio managers taking the time and effort to make the decisions, as well as the transactions. In other words, actively managed funds have higher expense ratios than passively managed funds. This creates the need for active strategies to produce higher overall returns than the market in order to offset the costs associated with it.
Passive investment removes a lot of that headache. Because you're basically investing in the market, you can buy index funds and hold them. Even on a singular security level, a passive investor isn't going to trade Ford stock. They're going to hold it and enjoy the dividends and long-term price appreciation. On a larger level, it takes much of the cost out for fund managers and analysts as well. Since the index funds and ETFs track indexes passively, investors incur fewer expenses for their management.
Which Is the Better Investment Method?
The merits of either strategy are largely dependent on the economic cycle and market conditions. Leading into 2008, when things began to get very shaky, an active investment strategy certainly would have helped reduce risk in many areas.
The decision is also largely dependent on your personal knowledge. I absolutely prefer active investment management to passive. Granted, this is definitely going against the herd these days, but I simply find that I get better results when I am active in my positions.
Being younger, I work with smaller amounts of capital. To that end, I seek out mistakes in the market where I can capitalize. Some years, I beat the market. In other years, I've lost that game. So it really comes down to your considerations on risk and ability to outperform.
You most certainly need a lot of time, research, and background in order to do active investing properly. Therefore, the average person that is simply looking to grow their retirement is most likely going to opt for a passive investment strategy. If you don't have time to look at your portfolio daily, read up on all the events and economic conditions surrounding your investments, and then do the due diligence required to make the right decisions in terms of buying and selling, then active investment is simply too much to handle.
Forgoing individual equities, even owning an actively managed fund requires knowledge and time. You have to research your portfolio managers. You have to research their holdings and past track record if you want to ensure you're not making a mistake.
Because of the extra work and risk, passive investment strategies are probably the best way to go for the average investor. You're helping ensure you don't experience downside below market levels, and you're keeping your trading and tax costs low.
Not all active managers beat the market, and the average investor simply doesn't need that headache. That doesn't necessarily make passive investment better, as you are certainly lowering your return potential. It simply means you're decreasing risk.
