Active Investing vs. Passive: Understanding Why You Need Both (+Detailed Guide)

Active vs. Passive Investing
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The debate over active vs. passive investing is frequently framed in terms of which method is superior. However, promoting one strategy over another may not be beneficial to new investors. Instead, a discussion about the differences between each approach, as well as when and how to use them in a portfolio, is often most beneficial to these investors.

Active vs. Passive Investing: An Overview

Considering that investors and wealth managers tend to strongly favor one strategy over the other, any discussion about active vs. passive investing can quickly devolve into a heated debate. But there’s also a scenario where both strategies can co-exist— that’s if you’re open-minded. Well, as an investor, you should. This is because even with your foolproof strategy in play, there’s always a better way to get things done. It is also important to note that taking this part promotes diversity in your strategy.

So, let’s carefully analyze both options to help us understand the differences between active vs passive investing. In the end, you might just come up with a strategy that considers a mix of both concepts. However, it’s understandable if you decide to stick to just one.

In any case, it wouldn’t hurt to have this knowledge at hand, just incase the need arises for it.

Active Investing

As the name implies, active investing is a hands-on approach that requires someone to act as a portfolio manager. The goal of active money management is to outperform the stock market and profit from short-term price fluctuations. It necessitates a much more thorough examination and the knowledge of when to enter or exit a specific stock, bond, or asset. A portfolio manager usually supervises a group of analysts who examine qualitative and quantitative factors before peering into their crystal balls to forecast where and when the price will change.

Active investing necessitates trust that whoever manages the portfolio will know exactly when to buy and sell. Being right more often than wrong is required for active investment management to be successful.

Passive Investing

You invest in the long term when you’re a passive investor. Passive investors keep their portfolios simple and limit the amount of buying and selling. This makes it a very cost-effective way to invest.

Basically, a buy-and-hold mentality is required for this strategy. That means resisting the urge to react to or predict every move made by the stock market.

Buying an index fund that tracks one of the major indices, such as the S&P 500 or the Dow Jones Industrial Average, is an excellent example of a passive strategy (DJIA). When these indices change their constituents, the index funds that track them automatically change their holdings; selling the stock that’s leaving and buying the stock that’s joining. This is why when a company grows large enough to be included in one of the major indices, it ensures that the stock will become a core holding in thousands of major funds.

Note: When you own small pieces of thousands of stocks, you simply participate in the overall stock market's upward trajectory of corporate profits over time. So, passive investors who are successful keep their eyes on the prize and ignore short-term setbacks, even sharp downturns.

Active vs Passive Investing: Understanding its Advantages and Drawbacks

One of the first decisions you’ll have to make as an investor is whether to use active or passive investment strategies when putting together your portfolio. Understanding the benefits and drawbacks of both investing styles, as well as the importance of diversifying your portfolio, can help you decide whether to use an active or passive investment strategy and when to use it.

The following are some key distinctions between active and passive investment strategies:

Advantages and Drawbacks of Active Investing

The goal of active investing is to outperform a benchmark or “beat the market.” The majority of active investment decisions are based on thorough asset research and analysis. Furthermore, market trends, the economy, and the political climate are other factors that can influence an active investor’s decision to buy or sell a specific investment.

Unlike an index fund, which aims to replicate the composition and returns of an index, an actively managed mutual fund aims to outperform its benchmark.

Advantages

The following are some of the advantages of engaging in active investing;

#1. Flexibility:

With active investing, portfolio managers and investors are not compelled to hold specific stocks or bonds. This means that they have a larger opportunity set to choose from and can take advantage of short-term trading chances.

Active investors can also manage their risk exposure by avoiding or selling certain holdings and market segments. This is more than I can say for passive strategies which, oftentimes, ebbs and flows with the market.

Short sales, put options, and other risk-mitigation strategies are also available to some active managers.

#2. Tax management:

Actively managed strategies can be tailored to meet the needs of specific investors, such as tax efficiency. An actively managed portfolio, for example, can harvest tax losses by selling underperforming investments to offset capital gains taxes on outperforming investments.

However, fees are often higher in actively managed portfolios than in passive portfolios. This is because you’re paying for a professional money manager’s advice on investment selection and portfolio management.

Small fees, on the other hand, can eat into profits and have a significant impact on performance. This makes it more difficult for actively managed funds to continuously outperform their benchmarks: beating the index isn’t enough; the fund must outperform by a margin large enough to cover expenses.

Meanwhile, In weighing between active vs. passive investing, active investing has a significant distinction in that active techniques offer a greater range of potential returns to investors. If you make solid investment decisions as an active investor, you could get a considerably bigger return than if you were to invest passively. If your investments, on the other hand, do not perform well, you may lose even more money.

Drawbacks

Obviously, active investing has a number of drawbacks. For example, in volatile markets, such as developing markets and small-company stocks, where information is scarce and assets are illiquid, active management can really shine. Other drawbacks include the following;

#1. Very Expensive:

The average expense ratio for an actively managed stock fund is 1.4 percent, compared to merely 0.6 percent for the average passive equity fund, according to Thomson Reuters Lipper. Fees are greater because all of the active buying and selling results in transaction fees; not to mention that you’re paying the salaries of the analyst team who researches stock recommendations. So, basically, over the course of decades of investment, all of those expenses can suffocate returns.

#2. Active risk:

Active managers have the freedom to buy whatever investment they believe will provide high returns, which is excellent when the analysts are correct but disastrous when they are incorrect.

Advantages and Drawbacks of Passive Investing

Instead of outperforming an index or benchmark, the goal of passive investing is to replicate its performance. Passive investment is a buy-and-hold strategy with low turnover that keeps costs down.

Buying index funds, which are meant to track the performance of a specific index, is one of the most prevalent passive investment options. The goal of passive managers is to possess all of the underlying assets in a market index proportionately.

Over the last few years, passive strategies have increased in popularity as research has shown that a passive benchmarked strategy can produce solid results with cheaper fees and less effort than an actively managed strategy.

Advantages

Passive investment has a number of advantages. Thee include;

#1. Low fees:

Because passively managed funds have less overhead, fees are often cheaper. There is no need to study benchmark holdings because no one is actively picking investments.

#2. Transparency:

In an indexed investment, investors usually know which stocks or bonds are owned.

Considering that index funds do not trade frequently, they do not generate a significant yearly capital gains tax.

Drawbacks

However, because you’re usually investing in a predetermined selection of securities, one of the biggest drawbacks of passively managed portfolios is that you have less control over your investments. This means that if specific industries or firms become too hazardous or underperforming, you won’t be able to make changes. Passive funds are basically restricted to a single index or fixed set of investments with little to no variation; as a result, investors are locked into those holdings regardless of market conditions.

On the other hand, You earn whatever the market earns based on the benchmark you choose when you invest passively. In other words, you fully share in market gains while also fully participating in market losses when the market falls. Basically, a passive fund may occasionally outperform the market, but it will never achieve the large returns that active managers seek until the market as a whole booms

If you have a longer time horizon or are in a position where you wish to minimize fees, passive solutions are often recommended.

You can have a mix of active and passive investment methods in your overall portfolio because they are not mutually exclusive.

Distinctive Points to Consider

So, which of these tactics is most profitable for investors? You’d expect that the skills of a professional money manager would outshine those of a basic index fund. They don’t, however. Passive investment, on the surface, appears to be the best option for most investors. Active managers have had dismal results in study after study (spanning decades).

All of this is evidence that even though passive investment outperforms active investing it may be oversimplifying something much more complex because active and passive methods are simply two sides of the same coin. For the most part, both exist for a reason, and many professionals combine the two approaches.

The hedge fund sector is a fantastic example. Hedge fund managers are well-known for being extremely sensitive to even little changes in asset values. Hedge funds also often avoid mainstream investments. However, according to research firm, Symmetric, hedge fund managers invested approximately $50 billion in index funds in 2017. Hedge firms only had $12 billion in passive funds ten years ago. Clearly, even the most aggressive active asset managers choose passive investments for a variety of reasons.

However, reports imply that actively managed Exchange-Traded Funds (ETFs) have performed well amid market upheavals, such as the end of 2019. So while passive funds continue to outperform active funds in terms of overall performance due to lower fees, investors are increasingly ready to pay higher fees in exchange for the experience of an active manager to assist them through market volatility.

Example of Active vs. Passive Investing

Tons of investing experts believe that combining active and passive strategies is the best method. Dan Johnson, for example, is a fee-only advisor in Ohio. His clients seem to prefer index funds because they want to avoid the wild swings in stock prices.

He prefers passive indexing but clarifies that,

“For advisers, the decision between passive and active management does not have to be binary. Combining the two can help to diversify a portfolio while also reducing risk.”

Andrew Nigrelli, a financial and wealth advisor and manager in the Boston area, agrees. He approaches financial planning from a goal-based perspective. He prefers long-term passive investment, indexing systems to pick individual stocks, and he actively encourages passive investing. However, he also believes that risk-adjusted returns are more important.

N.B: A risk-adjusted return is the profit from an investment that takes into account the level of risk that was incurred to get there.

According to him;

“When conditions change quickly, controlling the amount of money that goes into certain industries or even certain companies can really safeguard the client.”

Over a lifetime of saving for important milestones like retirement, there is a time and a place for both active and passive investing for most people. Despite the pain, many advisors end up combining the two approaches.

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