The Definitive Guide to Passive vs Active Investing
The debate on whether it’s better to be an active investor or a passive investor isn’t anything new. It’s been raging for many years. In this article we’ll look at the pros and cons of passive vs active investing.
The Goal: Provide you with helpful information about active and passive investments so you can make an informed decision on what’s right for you.
Passive vs Active Investing
Many websites, such as Wikipedia, automatically assume passive and active investing refer to the stock market. While it’s relevant in the stock market, it isn’t limited to the stock market.
As I mentioned in a previous article about investing for beginners, there are many different types of investments. Not all of them are focused on the stock market.
It’s practically impossible to cover passive vs active investing across all possible investments in one article. For the sake of simplicity, this article will primarily focus on passive vs active investing in the stock market.
NOTE: This article deals with investments made by private individuals. It doesn’t deal with how managed funds are managed by a professional fund manager.
Managed funds can be passively managed or actively managed.
Active fund management – An actively managed investment fund is where a fund manager makes decisions on how the fund’s money should be invested.
Passive fund management – A passively managed fund follows a market index such as the S&P 500. The goal of the fund is to match the performance of the index. It doesn’t require a fund manager to make investment decisions.
From a private investor perspective, managed funds are passive investments.
In this context, it makes no difference whether managed funds are actively managed or passively managed. Since the investor isn’t directly involved in the investment process it’s a passive investment.
At xUSD, investing is one of several important personal finance topics. At some point, most investors will have to choose between active vs passive investing. It’s an important topic and one that’s worthy of a detailed explanation.
What Is Passive Investing?
Passive investing means buying an asset and holding on to the asset with a long-term view. Passive investors don’t actively manage the asset after they’ve invested it in. They follow a buy and hold strategy.
An example of a passive investment is investing funds meant for retirement in a mutual fund or ETF.
What Is Active Investing?
Active investing requires a hands-on approach. The investor is directly involved in managing and controlling the investment process. Active investors often have a short-term investment horizon. They follow a buy and sell strategy of buying low and selling high.
An example of an active investment is stock picking where the investor researches, buys and sells individual stocks.
Pros and Cons of Passive vs Active Investing
Both active and passive investing have pros and cons. Here’s a list of the main advantages and disadvantages of being a passive investor versus an active investor.
Pros of Passive Investing
The main benefits of passive investing include the following:
Passive investing generally has much lower fees than active investing. For example, the fees for buying individual stocks are higher than investing in a mutual fund that follows an index as their benchmark.
Note: The fees for a passively managed fund are lower than for an actively managed fund.
As can be seen in the below example, fees have a huge impact on your investments.
Example: Portfolio Value From Investing $100,000 Over 20 Years.
In the above example, compared to a portfolio with a 0.25% annual fee (blue line):
0.50% annual fees (red line) will reduce the value of the portfolio by $10,000.
1.00% annual fees (green line) will reduce the value of the portfolio by nearly $30,000.
– Source: Investor.gov
Passive investing is known to reduce risk through diversification, and a long-term investment horizon.
A mutual fund or exchange-traded fund (ETF) typically invests in hundreds or thousands of stocks. Should one or two stocks underperform it would not have a major impact on your investment.
With active investing your risk is higher as active investors often only invest in up to 20 stocks. If one or two stocks underperform it could have a very negative impact on your portfolio.
Long-Term Investment Horizon
As a rule of thumb, the longer your investment horizon, the lower your risk.
Here’s a 5-year history chart of the S&P 500
Here’s a 10-year history chart of the S&P 500
– Source: TradingEconomics.com
The advantages of passive investing for the long-term is obvious from the above charts.
By following a buy and hold strategy you should see decent returns over a 5-year, 10-year, or longer period. This is based on the historic performance of indexes.
Investment returns over the short-term can be very volatile and can cost you money!
Stock analysis can be tricky unless you really know what you’re doing. Not everyone has the time and knowledge to accurately analyze a stock.
To make things easier for active investors, there are stock analysis software programs that can help. They can often explain the past performance of a stock buy pointing out buying and selling signals on a chart. But, as the saying goes, hindsight is 20/20.
Through the years I’ve looked at numerous stock analysis software programs and have spoken to many people selling them. They can be good at explaining the past. However, I have never come across a program that could accurately predict future stock movements.
There are many active investors that are good at stock picking. But, in general, passive investing may give you fewer headaches.
Cons of Passive Investing
The main disadvantages of passive investing include the following:
Certain Funds Can Be Overvalued
Certain stocks in a fund can be overvalued but you cannot exclude any stocks when you invest in the fund. This can cause the fund to be overvalued.
For example, a fund manager of an index fund is forced to buy all the stocks that make up the index. It’s done regardless of the growth and return prospects of individual stocks in the index. This can limit the upside potential of the fund.
Ties up Capital
Passive investing has a long-term horizon. A buy and hold strategy ties up your capital for many years. This opportunity cost can prevent you from profiting from other investment opportunities.
Diversification Comes at a Cost
Earlier in this article, I mentioned that diversification can reduce risk by not putting all your eggs in one basket. However, it comes at a cost. Whenever you try to reduce investment risks it has an impact on returns.
Passive investing takes a broad view of the market and stocks. It does help to reduce risks but a more focused view can potentially give you much better returns.
Pros of Active Investing
The main advantages of active investing include the following:
Flexibility and Control
You’re 100% in control. You decide what stocks you want to buy, when you want to buy it, and when you want to sell it.
Take Advantage of Undervalued Stocks
As mentioned earlier in this article, an index fund has to acquire all stocks in the index. This is done regardless of whether certain stocks are overvalued.
As an active investor you can build up your own stock portfolio. You can add stocks that are undervalued and offer huge upside potential. This can lead to much bigger returns than can be achieved by investing in index funds.
More Freedom and Fewer Rules
In America, the regulatory body responsible for oversight of fund management and securities is the U.S. Securities and Exchange Commission (SEC).
The mission of the SEC “is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”
Fund managers are limited to what they may and may not do. They don’t have the freedom to make decisions that don’t comply with SEC regulations, even though such decisions may benefit investors.
As an active investor you have more freedom than a fund manager to make investment decisions. Let’s use the 5% rule as an example.
The 5% rule says no single stock should represent more than 5% of a stock portfolio.
Based on this, an active investor should have at least 20 different stocks in their portfolio. None of the stocks should exceed 5% of the value of the portfolio.
The 5% rule encourages diversification, which is in your own best interests. However, if you don’t have the time or money to manage 20 different stocks, you can invest in fewer stocks.
For example, let’s assume you advertise on Facebook. You believe Facebook stock is about to take off based on some innovative changes they’re making to the platform. Why should you have to buy 19 other stocks as well? As an active investor, you don’t have to.
Hedging and Risk Management
There are several ways active investors can hedge their bets using techniques such as short sales or put options. It’s useful if an investor thinks the value of a stock may drop but doesn’t want to liquidate the stock holding.
Fund managers of index funds aren’t able to hedge their bets like active investors can. Since index funds have a huge number of stocks, diversification is the best “hedge” they have.
Many years ago a fund manager told me: “The perfect hedge is only found in a Japanese garden.” Hedging can reduce risks but it comes at a price. It will have an impact on your returns.
Cons of Active Investing
The main disadvantages of active investing include:
Investing in individual stocks on the stock market is a lot more expensive than for example investing in index funds.
Can Underperform the Market
If you have no experience picking stocks, and don’t have the skills or time required, it can cost you money. Many active investors beat the market but just as many, if not more, underperform compared to the market.
Frequently Asked Questions (FAQs)
Here are some frequently asked questions.
Is Passive Investing Better Than Active?
Whether passive investing is better than active investing will depend on your investment goals, skills, and available time.
If you have a long-term investment horizon, aren’t a skilled investor, and don’t have a lot of time, go for passive investing. If you want to make money over the short-term buying and selling stocks and know what you’re doing, go for active investing.
Based on the above, passive investing isn’t necessarily better or worse than active investing. Both options can work well if you choose the one that’s right for you.
Is Passive Investing Bad?
Passive investing is neither good nor bad. It has advantages and disadvantages. If your strategy is to buy and sell stocks over the short-term, passive investing isn’t your best option. This doesn’t make it a bad investment choice in general though.
What Is The Best Passive Income Investment?
One of the best investments to earn passive income is dividend stocks. These are stocks that have a sound track record of paying out high dividends.
If you’re an active investor you can buy shares in any high dividend stock. Some stocks worth considering include:
Altria Group Inc. (NYSE: MO)
National Health Investors Inc. (NYSE: NHI)
Edison International (NYSE: EIX)
Merck & Co., Inc. (NYSE: MRK)
Microsoft Corporation (NASDAQ: MSFT)
Texas Instruments Inc. (NASDAQ: TXN)
If you’re a passive investor, here are some funds worth considering:
Vanguard Real Estate ETF (VNQ)
Vanguard Utilities ETF (VPU)
Vanguard High Dividend Yield ETF (VYM)
Fidelity Dividend Growth Fund (FDGFX)
Over the past couple of years robo-advisors have become a very popular choice with passive investors. By investing with a robo-advisor you get the benefits associated with passive investing. However, they also offer some additional advantages.
Robo-advisors manage your investments on your behalf. The difference between them and traditional mutual funds and exchange-traded funds (ETFs) is they offer more customization.
When you open an account with a robo-advisor, you complete an online questionnaire. This provides them with relevant information about your financial situation, long-term goals, and risk tolerance. Based on your answers, you’re given recommendations on how you should invest your money.
The whole process is automated with little to no human interaction which helps keep costs down.
Some of the best, most popular robo-advisors are:
We’ve covered a lot of ground in this article about passive vs active investing.
We looked at the differences between passive investing and active investing. We also went through the main advantages and disadvantages of passive vs active investing.
Both passive investing and active investing offer many different benefits to investors. The one isn’t necessarily better or worse than the other one.
Passive investing is a good option if you want to invest for the long-term and follow a buy and hold strategy. An option worth considering is robo-advisors that offer more customization based on your needs and risk profile.
Active investing is a good option if you want to invest over the short-term and follow a buy and sell strategy.
Which strategy appeals to you the most? Do you see yourself as a passive investor or an active investor? Or perhaps you want to split your investments between passive investing and active investing? Let me know in the comments below.