If you ever have a group of investors around you, a discussion about active investing vs passive investing can turn into a heated debate. This is because wealth managers and investors tend to favor one over the other.  

But before you start planning the best strategy to follow, let's understand the difference between active investing vs passive investing.

Active Investing vs Passive Investing - Table of Contents

What is Active Investing?

Active investing is taking a hands-on approach that requires an active portfolio manager. The main goal of active money management is to beat stock market average returns and take complete advantage of short-term price fluctuations. This involves getting a deeper analysis to know when to pivot into or out of the stock, bond, or asset. Portfolio managers are tasked with looking over a team of analysts who check multiple quantitative and qualitative factors to determine when the price will change. 

Active investing needs the experience and confidence that whoever manages the portfolio knows the best time to buy and sell.  

Advantages of Active Investing

The advantages of active investing are: 

• You earn higher returns: When you are skilled, you can get higher returns by researching and investing in any undervalued stocks than by buying just one cross-sectional portion of the market using an index fund. But to succeed, you need to have the expertise that can take years to develop. 

• Fun to follow the market and test skills: If you find it entertaining to follow the market as an active trader, then spend all your time doing so. 

• Tax management: A proper portfolio manager or financial advisor can utilize active investing to make trades that offer gains for tax purposes. This is termed tax-loss harvesting. At the same time, this can be used with passive investing; active investing yields more opportunities.

Disadvantages of Active Investing

The disadvantages of active investing are: 

• Highly expensive: According to the Investment Company Institute, the average expense ratio for an actively managed equity fund is 0.68%, whereas, for passive equity funds, it is 0.6%. Fees are higher because all active investments trigger costs, including the salaries of analysts doing research. All these fees over the years can kill profits. 

• Active risks: Active managers can buy any investment when they think it will bring in returns, which is good when the analyst is correct. But it can be detrimental when they are wrong. 

• Exposure to trends: In active investing, whether pandemic-related or meme stocks, it is easy to follow trends. Think about an investor who planned on buying the Peloton stock for $145 on 4th January 2021. But as of July 2022, with the end of the pandemic, the stock fell to less than $10.

So, it isn't easy to follow trend investing as you cannot plan whether you are at the tip or if there is still room for growth.

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What is Passive Investing?

If you consider yourself a passive investor, you are in for the long haul. Passive investors limit themselves to the amount they buy and sell within their portfolios. This is a highly cost-effective way to invest. The main functionality for this is the buying-and-holding mentality which means resisting all temptations to react to the stock market's every move. 

Advantages of Passive Investing

The advantages of passive investing are: 

• Lower costs: A reduction in trading volumes is associated with passive investing, which can lead to lower costs for individual investors. Also, passively managed funds charge lower expense ratios than most active investments, as there is not much upkeep needed. 

• A decrease in risk: As passive investing is more fund-focused, investors invest in hundreds and thousands of stocks. So, this offers easy diversification of portfolios. This makes the likelihood of losing too much money difficult. 

• Complete transparency: With passive investing, what you see is what you get. The index your fund tracks are included in the name. 

• Higher returns: Passive funds always give higher returns if you plan for long-term investments. Over a 20-year, over 90% of index funds tracking corporations of all sizes outperformed all their counterparts. 

Disadvantages of Passive Investing

The disadvantages of passive investing are: 

• Not flashy: If you want excitement in your life and see skyrocket returns, passive investing is not for you. 

• No proper exit strategy: As passive investing is built on long-term planning, it does not have an off-ramp, especially in severe market downturns. But, when the market recovers from every problem, there is no guarantee that it will do so quickly. That way, you can make sure your portfolio is more conservative.

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Active Investing vs Passive Investing Examples

Many investment advisors believe that the best strategy is merging active and passive styles, which helps minimize the swing in stock prices, especially during volatile periods. Active investing vs passive investing management does not have to be a 'this or that' for advisors. You can combine the two to diversify your portfolio and can help manage risk. People with large cash options can actively look for options to invest in ETFs once the market has pulled back. For retirees who are worried about their income, investors can choose specific stocks for growing dividends while maintaining a buying-and-holding attitude. 

Also, it is not only a matter of returns but rather a risk adjustment of returns. Risk-adjustment return is the profit gained from the investment while considering the risk levels taken to achieve that return. Control the amount of money that goes into specific sectors when conditions change quickly to protect the client. 

In most cases, there is a time and place for active investing vs passive investing to save for major milestones like retirement and tuition costs. Most advisors use these two strategies to ensure their clients get returns.

Active vs Passive Investing Differences

Here are the key differences between active investing and passive investing:

Active vs Passive Investing: Which Strategy Should You Choose?

The best trading strategy that will work better depends on how much time you can devote to investments and whether you want the best success. 

When is Active Investing better?

• You have enough time to spend investing. 

• You like doing research and enjoy the challenge of removing millions of smart investors. 

• You do not mind any underperforming, especially in any year, for the pursuit of investing.

• Having the chance at the best returns in a year, even when it means your stocks underperform.

When is Passive Investing better?

• You get good returns over time and want to give up a chance for the best returns in the given year. 

• You want to beat other investors, even the pros.

• You like and are comfortable investing in index funds. 

• You do not want to spend time investing, especially if you purchase index funds. 

• You want to minimize taxes in the given year.

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Conclusion

If your aim as an investor is to reduce fees and trading costs, the all-passive portfolio is perfect for you. Some investors are more concerned with risk, returns, and liquidity than fees. 

When planning to look at active investing vs passive investing, a combined approach can provide investors peace of mind. A passive, long-term strategy works on autopilot, whereas an active investing strategy is short-term and lets them explore recent trends without altering their long-term goals.