Ever heard a financial expert speak about active and passive investing strategies and wondered exactly what those terms really mean? We’re here to help you understand each of them, and their main differences. With that knowledge, you’ll be able to determine which strategy is right for you, or whether you might benefit from a mix of both.
In basic terms, active investing is a more intense type of financial strategy, one that aims to beat, or outperform, the annual performance of market indexes. Passive investing, on the other hand, is a more hands-off approach that seeks only to match market performance.
A closer look at active investing
As the name suggests, there’s a lot of activity in an active investing strategy. Some of that takes the form of frequent trades, each of which are driven by high levels of research and analysis in search of the best value and opportunity.
While it is possible to manage your own active investment strategy, it’s a heavy workload that requires both frequent attention and a well-developed understanding of the financial world. More commonly, investors hire a professional to actively manage their money.
Even with the attention of an experienced investment advisor, there’s no guarantee an actively-managed strategy will outperform its benchmark index in any given year. In fact, more often than not, they don’t. When actively managed investments do manage to beat the indexes, investors need them to do so by a big enough margin that the manager’s annual fees don’t eat up the difference.
A closer look at passive investing
With passive investing, buying decisions tend to be made for the long-haul. Ignoring the daily ups and downs, investors try to make regular, consistent purchases of a broad basket of stocks, working towards their goal of mirroring the performance of market indexes. Broadly speaking, the longer you hold a passive investment, the better its performance is likely to be.
Thanks to the lower intensity in both transactions and analysis, the fees for most passive investing strategies are substantially lower than for active ones, meaning individual investors end up keeping more of their own money in their own pockets.
Still, as with active strategies, there are no guarantees. Passive investment strategies typically manage to match market performance, but they can’t overcome market declines. If an index falls, your passive investments will decline in value, too. In general, however, passive investing is a far less risky strategy than active investing.
What’s the best approach?
Life stage and risk tolerance are the two most important factors to weigh before making any major investment decision, including choosing between active and passive strategies. Where you are and how you feel will help inform your choice. For instance, an investor who is close to retirement and doesn’t have time to recover from a market dip might benefit from an active, albeit conservative, investment strategy as a means to protect wealth in the face of potential downturns.
Of course, choosing between active and passive investing is not an either-or decision, and many investors succeed with a mix of both styles. In doing so, it may be beneficial to lean more passive when investing in areas of the market that have historically proven to be more volatile, or difficult to predict, while being more active with your investment choices in more stable areas of the market. For instance, if international stocks have a strong record of profitability but domestic stocks don’t, go passive with your domestic equity investments and be more active with international ones.