Few topics divide opinion in financial circles more than discussions about active and passive investing. In this article, we will explain the two investment approaches, the advantages and disadvantages of each approach, and--depending on one’s investment goals--when to pursue a passive or active investment strategy.
Let’s start with active investing. Active investing involves taking a ‘hands-on’ approach to investing. That means someone, typically a portfolio manager, is tasked with analysing relevant market information and overseeing the investment decision process. Active investing can take the form of investing in a bespoke fund to stock picking through an online trading account. The goal of active investing is to beat the stock market’s average returns and knowing when to buy and sell assets. Active managers overseeing a fund typically charge a fee for their services, meaning that investors must pay a premium to benefit from above average returns.
Unlike active investing, passive investing requires taking a “hands-off” approach to investing. Passive investing typically involves buying a pre-defined investment product, like an index fund, that tracks a basket of bonds and stocks or a stock index like the S&P 500. That means passive investors don’t have as much choice as active investors. Passive investing is usually preferred by long-term investors who want to buy and hold assets and are willing to limit their risk exposure to secure average returns. Passive investing fees are considerably lower than fees charged by active managers, but there’s also a ceiling on potential returns.
Potential for higher returns: Active investing aims to outperform the market, which means there is a chance for higher returns compared to passive investing strategies that simply track the market.
Flexibility: Active investors can adjust their portfolios based on changing market conditions and can respond to opportunities and risks more quickly than passive investors.
Capitalising on market inefficiencies: Active investors can identify undervalued assets or companies with strong growth potential that might be overlooked by the broader market.
Higher costs: Active investing typically incurs higher costs due to frequent trading, research expenses and potential management fees.
Lack of diversification: Some active investors may become too focused on specific stocks or sectors, leading to a lack of diversification.
Difficult to be consistent: While active investors aim to outperform the market, consistently beating the market over the long term is challenging.
Lower costs: Passive investing is usually cheaper than active investing because it involves less frequent trading and requires less research.
Greater diversification: Strategies often involve investing in broad market indexes or exchange-traded funds (ETFs), which provide instant diversification across a wide range of assets.
Consistency: Passive investing reduces the risk of underperforming due to incorrect stock picks or market timing and provides stable and predictable returns.
Limited upside: Investors are unlikely to achieve significantly higher returns than the overall market, even during bull markets.
Market dependency: Passive investing is dependent on the overall market's performance. During extended bear markets or stagnant periods, passive investors may experience lower returns.
Lack of control: Passive investors cannot tailor their portfolios to individual preferences or exclude specific companies or sectors that they may find objectionable.
When to invest actively and passively?
Investors with a higher risk tolerance and the ability to withstand potential market swings may find active investing is for them. Active investing allows for greater customisation, but it also requires time an effort. Investors that favour this approach can buy an actively managed mutual fund or hedge fund.
In contrast, investors who prioritise simplicity, lower costs and broader market exposure may prefer passive investing. Passive investing is well-suited for investors with long-term financial goals or those who lack the time and interest to stock pick. Products such as diversified index funds or ETFs offer a path to passive investing.