Active Investing Versus Passive Investing

Passive investing beats most active investors over the long term. Shutterstock

The “go get ’em” attitude suits many people. Some want to be actively involved in everything, including investing. Others may just be happy with their lives and don’t need to invest actively. They are content with being passive investors.

Both investing strategies have their place and can be successful. But which strategy is most sound for both the long term and the short term, and which one would suit your needs and goals?

What Is Active Investing?

Active investing is just what it sounds like. Investors spend hours combing through stocks, prospectuses, and reports, looking for the best return.

A lot of work and research goes into finding the perfect needle in a haystack. And when you do, you feel like you beat the market.

An active investor’s goal is to outpace the market. They’re looking for a big win.

Active Investing Advantages

There are several advantages to active investing.

Active investing can be used to take advantage of short-term opportunities. You can use swing trading—i.e., trading that attempts to capture short-to-medium-term gains over a few days or weeks—to take advantage of momentum.

Active investing allows for risk management. You or your money manager can adjust your portfolio to align with prevailing conditions. If the market is heading toward a bear market, you can quickly react and protect your investment.

Money managers can meet specific needs, such as providing diversification, retirement income or a targeted investment return.

There’s a potential for a large score.

Active Investing Disadvantages

Active investing has many disadvantages.

Many investors buy and sell at the wrong time. They use their emotions to buy and sell. They tend to buy when the price has run higher and sell after it has already fallen. Either way, they’re losing money.

It’s hard to beat the professional active traders, although it may look easy. Day traders tend to be the most active investors. They are also the most consistent losers. They are facing off against the high-powered and high-speed computerized trading algorithms that dominate the market. They’re going up against a lot of expertise they may not have.

This is especially true for active retail investors.

Over the long run, approximately 90 percent of retail investors lose money in the stock market. That’s because with commission apps like Robinhood, more people are trying to beat the market.

Time is the big element when it comes to active investing. It takes a lot of research, and if you hire a money manager, you’re paying, which can defeat the purpose.

And since you’re not deferring your capital gains, you could have a hefty tax bill at the end of the year.

Because of the often-aggressive trading, active investing is high risk.

What Is Passive Investing?

Passive investing is focused on a long-term buy-and-hold approach. Passive investors typically buy an index fund.

By using an index fund, passive investors avoid analyzing individual stocks and trading in and out of the market. They don’t have to research each stock—it’s done for them.

Passive Investing Advantages

Passive investing beats most active investors long-term. Think of it this way: Passive investors’ goal is to be in the market. They own the market through an index fund and receive the market’s return through that fund.

For example, the S&P 500 Index’s average annual return has been about 10 percent, making passive investing easier to succeed at. Warren Buffet has often touted passive investing. He accurately said, “If you like spending six to eight hours per week working on investments, do it. If you don’t, then dollar-cost average into index funds.”

By investing in index funds, you don’t have to do research.

As Buffet stated, the time element is minimal. You mainly have to look at your investments yearly at tax time. With taxes, buy-and-hold investors defer capital gains taxes until they sell. Since it’s a long-term proposition, you probably won’t see a yearly tax bill.

Passive investing is also less expensive than active investing.

Passive Investing Disadvantages

With passive investing, you may earn an average return. Buying a collection of stocks through an index fund is bound to have both winners and losers. You may think you'd do better if you could pick the winners.

Passive doesn’t mean ignoring. You still must know what you own. Many people are relaxed about this and have no idea what funds are in their portfolio. You can’t be completely disengaged.

Passive investing may make you slow to react to risks. Even if you’re taking the long-term approach, there are still risks.

Investing Depends on Your Goals and Risk Tolerance

It takes some work, but active investing can bring bigger returns. It also however comes with a lot of risk. You must have a high-risk tolerance to participate. But active investing might be for you if you’re looking to beat the market with a short-term investment.

Passive investing aims for strong long-term returns. It minimizes the amount of buying and selling. However, it will not beat the market or have large short-term returns.

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