Active vs. Passive Investing: Understanding the Difference
Posted by: Joseph Kuo | August 13, 2021
During the first quarter of 2020, major online brokers saw new accounts grow as much as 170 percent. Whether you are working with a financial advisor or investing on your own, it’s important to understand the fundamental differences between two common approaches: active investing versus passive investing.
What Is Active Investing?
Some investors may look at active investing with a goal of “beating the market”, outperforming specific standard benchmarks, or earning a certain amount of investment income per year. In order to invest actively, investors may follow investment trends and buy or sell as investments rise and fall.
Investment advisors may actively invest in, or recommend, assets such as:
- Mutual funds
- Exchange-traded funds (ETFs)
- Portfolios of stocks, bonds and other holdings
The general idea surrounding active investing is that if things go well, you may be able to outperform the market, even including the fees you pay to your advisor or broker. Performance, however, is never guaranteed.
Active Investing Considerations
If you’re working with an investment advisor or team of advisors, a person (or team of analysts) may be picking individual stocks or sectors of the market to invest in. This could either be you or your advisor.
Fees vs. Performance
Having an advisor or advisory firm to actively manage your portfolio can incur higher fees than those who follow a passive investment strategy. Because of this, an investor would need to beat the market by a certain percentage in order to make paying the higher fees worth it in the long run. Also, because active investment leads to more transactions, there will be a greater chance of more taxes from the sale of proceeds.
What Is Passive Investing?
By practicing passive investing, you aim to maximize your returns while minimizing the amount of buying and selling that you do. With this strategy, investors may buy and hold their stocks and bonds in passive funds or passive index funds.
These funds rise and fall to match the performance of certain indexes. Thus, passive investments are not meant to beat or outperform the market, but rather match the market’s performance.
Passive Investing Considerations
Potentially Lower Fees and Taxes
Because passive funds don’t have such a hands-on human component to them, they tend to incur fewer fees than active investments. Different funds will have different fee ratios, so it’s important to know what this ratio and factor it into the potential returns when investing in a fund. Because there are fewer transactions in a passive investing strategy, there are fewer chances to incur taxes from capital gains.
An investor will know exactly what stocks or bonds their indexed investment contains. For some, this transparency and consistency may be comforting or reassuring to know as they work toward their long-term financial goals.
Which Approach Is Right For Me?
Some investors may find a mix of both active and passive investments the right move for diversifying their portfolio. With the lower fees passive investments tend to incur, it may be an appealing option for investors who don’t have the time or desire to actively manage their investments or can’t hire someone to do it for them. If you have the time or don’t mind the additional fees, an active investment strategy offers a potentially higher rate of return, but with an accompanying higher risk.
How you choose to invest will likely come down to your priorities, desired personal involvement and long-term goals. If you’re unsure what direction to take your investments, an investment advisor can help explain your options and provide further guidance.