The Ultimate Guide to Active and Passive Investing: What You Need to Know

In the investment world, two distinct philosophies stand at the forefront: active and passive investing. Each reflects a method of managing money and a mindset about risk and reward.

Active investing embodies a dynamic approach, where stock picking fuels the ambition to outperform the market, while passive investing favours a “set it and forget it” mentality. This approach aligns with a philosophy of long-term growth through steady, consistent returns, often achieved by tracking market indices.

But what is active and passive investing?

What is Active & Passive Investing?

Active investing is a strategy that involves buying stocks to outperform a specific benchmark, often a market index. It’s a hands-on approach, where investors try to pick stocks with a bright future and the potential to beat the market long-term. Active investors often do hours of research, calculations, and analysis to determine the best entry prices to maximise gains.  

On the other hand, passive investing is a set-it-and-forget-it approach. Instead of trying to beat a benchmark, passive investors are satisfied with matching the market’s returns. Passive investing doesn’t require as much research as active investing.

While active investing is biased toward individual stocks, passive investing generally involves dollar cost averaging into shares of exchange-traded funds (ETFs) that track market indices like the FTSE 100 or the  S&P 500. 

Advantages and Disadvantages

It is well known in the investing community that active money managers tend to underperform benchmarks more than they outperform them. In a study conducted by S&P Global, over 15 years ending in 2021, only about 4.5% of professionally managed portfolios in the US outperformed their benchmarks consistently. This figure drops to about 2% after accounting for taxes and trading costs.

So, what are some advantages and disadvantages of each investing philosophy?

Active Investing Advantages and Disadvantages

Active investors have flexibility with their investments – they can choose from thousands of listed companies to invest in. Also, active investors can freely move to more defensive positions like cash and government bonds before and during market declines.

Active investors have more trading options – active investors have more ways to generate investment income, such as shorting stocks (profiting when a stock price falls) and through premiums on put and call options. Active investors can substantially increase their investment return using these additional trading options.

Active investors also get tax advantages – they can use losses in their portfolio to offset their gains and pay less in capital gains tax. If an active investor has an investment with $10,000 in capital gains and another with $4,000 in losses, when both investments are sold, they can use the loss to offset their gains and only pay tax on $6,000.

But there are some drawbacks…

High risk – active investing is inherently risky. When you want to beat the market, you must do what others aren’t willing to do. When you’re right, you win big. But when you’re wrong, money vanishes very quickly.

Higher fees – especially true if your investing account provider charges transaction fees. Each time you jump into and out of a stock, you trigger transaction and brokerage costs. Even though these costs may be as low as 0.5%, they will add up over time and hurt your investment returns. Not all platforms have transaction fees, though. Some are free. 

Passive Investing Advantages and Disadvantages

Passive investors deal with lower fees – passive funds charge lower expense ratios than most active funds since very little research and portfolio upkeep is required. The lower the expense ratio of the ETF you invest in, the fewer fees you pay and the more money you keep.

Passive investing is known for its low risks – when you own passive funds, you own small pieces of several companies. If you buy an ETF that tracks the FTSE 100, you own small pieces of the 100 largest companies in the UK. Therefore, the likelihood of one poor-performing stock having a considerable impact on your portfolio is very low.

But if you are or want to be the cool kid on the block, passive investing may not be for you.

Passive investing is not flashy – if you’re looking for the excitement associated with quick returns, passive investing is not the place to be. Passive investing is a slow and steady way of building wealth.

Limited investment returns – because passive funds track specific indices, passive investors can only match what the index returns. If an index returns 10% annually, passive investors can only generate 10% annual returns from investing in an ETF that tracks that index. 

So, with their respective advantages and disadvantages, which strategy is better?

Which is the Better Strategy?

Being an active investor allows you the flexibility to choose your investments and potentially make higher returns. As a passive investor, you face lower risks at the expense of higher returns.

But it doesn’t have to be an either/or choice.

The greatest investors use a mix of the two strategies to build their fortunes. They call the mix value investing.

Coined by Benjamin Graham, the father of value investing, value investing is deriving the intrinsic value of a stock by using the company’s assets, earnings and cashflows and comparing it to the market value (the stock’s current price). If the intrinsic value exceeds the market value, the stock is considered undervalued and presents a buying opportunity.

In combining active and passive investing, we can deduce some advantages. They are as follows.

Tax efficiency – since you are holding investments for the long term, you save on capital gains tax (you aren’t paying them every year). Similarly, you can reduce your taxable amount by offsetting gains with investment losses.

Relatively low costs – because you only buy when a stock trades considerably below its intrinsic value, you don’t encounter as many transaction fees. You only pay expenses related to owning the investing account if the platform you use isn’t free. 

The drawbacks, on the other hand, include:

Hours of research – you’ll have to look for companies you want to own, read annual and quarterly reports to understand (and keep up with) the business, evaluate the management team and perform valuations to determine the stock’s intrinsic value. 

Patience – sometimes, the companies you want to own may be trading higher than their intrinsic value, in which case you shouldn’t buy, or sometimes they won’t be trading at a high enough discount to warrant a buy. Patience is fundamental to value investing. 

Value investing is not trendy – value investors don’t follow the herd, even if it means not jumping on trend trains and missing out on huge gains. They stick to buying quality businesses when undervalued and holding them long-term.

Which Strategy Should You Choose?

Choosing an investment strategy is a personal choice and depends on your financial goals and individual situation. 

If you’re a younger investor, active investing may intrigue you since you have a longer investing time horizon to make mistakes, recover from them and work out a system that works for you. The closer you get to retirement, the more conservative you should become because you have less time to recover from investing mistakes.

You can always change your investment strategy, so don’t think if you start as an active investor, you can’t become a passive investor and vice versa. Just know what you’re getting yourself into before you get into it! 

If you want the benefits of both strategies, you can always combine them. After all, some of the greatest investors have built fortunes doing so.

Summary

The choice between active and passive investing isn’t merely a matter of preference; it reflects individual goals, risk tolerance, and the philosophy one adopts toward wealth-building. Active investing offers flexibility and the potential for higher returns, driven by a commitment to conduct detailed research and analysis. Yet, it comes with significant risks and costs that can erode potential gains.

Conversely, passive investing embraces the idea of long-term growth through diversified exposure, prioritising stability and lower fees over the thrill of rapid returns. While it may seem less exciting, it provides a solid foundation for many investors, particularly those with a lower risk appetite.

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