Ready to navigate your way into the foreign lands of investing? Great! One of the first topics to cover is the difference between active investing and passive investing. Which one will be right for you? Let’s dig in and find out!
What Is Active Investing?
Active investing, as its name suggests, involves an active approach to selecting your investments. The idea behind active investing is that by conducting a careful analysis of the investment options (for example, stocks and bonds), you can make an informed choice about what’s most likely to do well within a given market and then reap the benefits.
There’s often research and analysis involved -- so if you’re into macroeconomic analysis, technical analysis, or any other kind of analysis, you might be interested in hand-picking your own investments. You can also hire a financial advisor to help you manage investments, if that’s more your style.
What Is Passive Investing?
Passive investing is a much less involved approach to investing. Rather than picking and choosing individual pieces of a market or fund and trading them frequently, you go in on the whole shebang. You’re investing in the total outcome of the entire market or fund. The main task is to choose the index funds that make the most sense for you and your goals over the period of time you’re planning to invest.
How Does the Difference Look in Real Life?
If the difference between active and passive investing is clear as mud for you, here’s an example to help: Ever heard of the S&P 500? Its full name is the Standard & Poor’s 500, and it’s a collection (or an “index”) of 500 individual American stocks.
As an active investor, you may want to study all the companies represented in the S&P 500 and put together a mutual fund that invests in the best 100 individual stocks. As a passive investor, you’d invest in an S&P 500 index fund, which covers all the stocks in the S&P. You’re investing in the entire market.
To make it a sports analogy, active investing is like studying all the MLB teams in the preseason and betting on your pick for which teams would be in the playoffs at the beginning of the season; passive investing is like owning all of Major League Baseball. A winning pick might get you a huge return, but owning the proceeds from ticket sales and licensing is a lot more reliable.
Can I Get a Point-Counterpoint?
There are pros and cons to each type of investing. Let’s break down the key points.
Active investments typically come with higher fees because active management requires a lot more time and movement in the market. You're actively choosing to buy and sell. The big risk in actively management investments is that they involve a choice, and they require that you have utmost confidence in the chooser (whether it’s yourself or the professional you hire).
Choose well, and your hand-picked mutual fund could outperform the market. Choose poorly, and your returns may fall below what you would have made by sticking with a passive strategy.
Passive investments, on the other hand, are associated with lower fees (because there’s a lot less hands-on work to do). They’re also associated with lower capital gains distributions, which are reported on your taxes; lower distributions mean lower tax bills. Passive investments also carry less risk, because the return is effectively the average return over the investment period. In other words, the proverbial apple cart is much larger and therefore more difficult to tip. This is especially true in the case of long-term investing.
Studies that look into the comparative performance between actively managed investments and passively managed ones show that there’s no major difference in returns over the long haul, due in large part to the higher costs associated with active investments. That’s not to say that every single actively managed portfolio will end up in the same place as a passive fund in the same market; it just means the likelihood isn’t necessarily a given.
All of that said, generally speaking average investors are better served by a passive approach. A single blog post can’t tell you what’s right for your financial future, but having a basic understanding of passive vs. active investing should help you find the right direction. It’s critical to speak with a financial advisor when you’re making investment decisions.
About the Author: Ashley Gainer is a writer and business coach who makes great content for entrepreneurs and small businesses and teaches other writers how to do the same. You can find her online at ashleygainer.com or on Twitter at @AGEditorial, and join her work-at-home tribe of parent-preneurs who are committed to being parents first.