Active vs Passive Investing – Differences That Matter

Active vs Passive Investing is about more than just the “style” of investing. It’s fundamentally about the ethos one takes towards investing as a whole. But what do these 2 different types of investing actually mean? And which one should you opt for? Let’s find out.

If you’re newer to the concept of investing, the most stressful part of it may be the idea that you have to constantly watch your portfolio and tweak it.

Most newer investors put money in, watch the account immediately fall a bit, and decide the risk of losing everything is too great.

This will inevitably lead to losing money, but this doesn’t have to be the case. In fact, the whole point of this article is to help you avoid that.

Investing is a long-term endeavor, and whatever you invest needs to stay in the market for as long as possible.

The first decision you need to make to ensure that happens is to decide whether you’re best suited for active investing or passive investing.

We’ll explain active investing vs passive investing and help you invest in the way that best suits you.

What Is Active Investing?

The very first scenario we mentioned – about actively watching your investments and making tweaks – is actually the short way to describe an active investor.

It means that you’re watching your portfolio on a regular basis and making tweaks to your positions based on a core set of criteria.

Active investing isn’t about trying to time the market. That’s been proven mostly impossible thanks to the Efficient Market Hypothesis.

However, fundamental analysis of the data we have at our fingertips allows us to locate opportunities that can potentially lead to above-average returns.

While it takes some time to learn this, let’s explain what active investing might look like.

On the longer-term side, you might have an investor who will rebalance their portfolio once or twice a year.

When rebalancing a portfolio, you would locate those investments that are either over-performing or under-performing and make the decision to stay in those positions or sell out and redistribute that money to other positions.

A balanced portfolio is one that keeps to a specific split of positions, and adjustments are made to keep to that long-term strategy.

A method in the shorter term might involve reacting to market events and earnings reports as they get announced.

Let’s say, for instance, that indicators point to higher oil prices in the near future.

An active investor might set up a position not only to go long oil futures but also go long some big oil companies.

They might even get into a bit of hedging with other derivatives, but doing that correctly can require significant study and experience.

Benefits of Active vs Passive Investing

At the end of the day, active investors are continually consuming information and using that to find opportunities in the market on timeframes less than every decade.

Since the market provides investors with opportunities every single day, active investors have a better chance of finding those opportunities and jumping on board to realise better returns.

Also, active investors might have a better understanding of when it’s a good time to buy certain equities.

If a company’s stock price falls to historic lows, an active investor might see that as an opportunity to buy the company at a discount.

Note that stock prices falling to historic lows is not necessarily a reliable sign or signal of the company being sold at a discount.

It might equally signal that the stock’s present and future prospects look bleak at best.

Even though the short term might be rocky, active investors still have long term gains in mind as the goal.

Also, active investors can implement hedges on positions that can reduce losses in bear market scenarios.

Passive investors will almost never employ such tactics and will generally experience the full impact of market drops.

Drawbacks of Active Investing

Unfortunately, reading the market is quite challenging, to say the least.

Some people have a keen sense of what the market is doing from one day to the next while others will find difficulty in seeing the signs.

Actively investing opens one up to not only higher-than-normal returns but also higher-than-normal losses.

Data can provide a big edge even for retail investors but reading the wrong data or reading it with a biased perspective can lead one to believe they are correct only to get into deep water when they’re wrong.

Also, actively investing comes at a cost. Most brokers will charge on a per-trade basis.

The more trades you make, the more those commissions will eat into your profits.

This must be taken into account before placing a trade or else you might find that your edge is completely taken up by paying commissions to your broker.

What Is Passive Investing?

Passive investing, as you might imagine, is investing without actively managing your positions.

Index funds and mutual funds were created for just these types of investors.

Since most people don’t have time to dive into the data and create winning strategies, index funds were created to allow any investor to buy shares and have a stake in many, if not all, equities in a particular market.

Stock markets around the world generally grow over time.

So, the assumption is that, as long as you just leave your money alone to reap the benefits of capital growth, dividends, and interest payments, you will just keep compounding those returns and have enough to retire on.

Passive investing tends to involve broad diversification in mutual funds, but that’s not necessarily a rule.

Warren Buffett and Charlie Munger, for instance, have made their whole career on buying quality companies and sitting on them for several decades.

In short, quality over quantity can be a strategy for even passive investors.

If there are a few companies that have strong foundations, you simply need to wait for the right time to buy them and then let the growth carry you forward from there.

Many passive investors love dividend-paying companies because:

• They are usually strong companies,
• They pay dividends regularly, and
• The companies are diversified enough that market swings have less effect on their fundamentals, much less their solvency.

Benefits of Passive vs Active Investing

Passive investing has the benefit of costing far less than active investing.

Most index funds have extremely low management fees, perhaps costing up to 75 basis points (0.75%), though most even charge less than that.

If you’re investing in a tax-advantaged account, passive investing is especially attractive because you can avoid capital gains taxes every year.

Also, it’s worth noting that, while index funds are extremely cheap to manage, most large brokerage companies are now charging very little if anything at all to buy and sell stocks.

If you prefer the quality over quantity method, you could have an all-stock portfolio that not only grows in a tax-advantaged account but also costs nothing to enter and maintain.

Drawbacks of Passive Investing

With diversification and safety of assets almost always comes limited growth.

While you will experience growth over time, your growth will be stunted by the fact that you are diversifying in order to avoid severe losses in your account.

Also, most index funds are managed by someone else, and you will not have any say at all in the management of those funds.

If you’ve got a type-A personality and like to be in control, passively investing in index funds might prove difficult.

Active vs Passive Investing – Which One Is Better?

There is no right answer here. Obviously, all investing comes with risks whether you’re investing actively or passively.

But the only question you need to answer is this one: Are you interested in learning how the market works, what all those pesky ratios mean, and generally staying updated on financial news?

If you answered yes to that, you might have what it takes to become an active investor. We’re not talking about day trading.

We’re talking about learning and setting up data-driven investing strategies that can help (not guarantee, mind you) lead to an exciting investing journey.

Is Vanguard Considered Active or Passive?

Large companies like Vanguard are actually meant for both active and passive investors.

They and other firms like them offer hundreds of funds for passive investors, but they also offer access to free stock trades.

Anecdotal evidence suggests that, for the most part, Vanguard’s customer base comprises more of passive investors vs active investors.

What’s Next – Active or Passive Investing?

Let’s be clear, there is absolutely nothing wrong with passive investing.

If you decide that passive investing is for you, the most important thing to know is that you just need to start putting money into passive investments.

The only real way to grow capital anymore is in the financial markets, and that means putting your money to work now so you have enough time to watch it grow.

Passive or active, investing is a journey that requires some preparation.

Deciding which type of investor you want to be is an important first step, but we can help you figure out all of the steps that come next.

For instance, if you’re genuinely interested in gaining a solid command of financial markets and securities, you should definitely explore our variety of rigorous finance and investing courses.