Passive vs. Active Investing

Guideline for which investing route is right for you, your risk tolerance and your preferences

It’s the great debate between many investors: Is it better to use a passive or an active investment strategy?

The answer isn’t as clear cut as you might want it to be. Both passive investing and active investing have their positive and negative attributes. It’s less about which one is better and more about which one is right for you.

Having trouble determining how to invest your money? We’re here to help! (Plus, no one’s a master yogi of investing on their first try!)

Before we jump in, we highly recommend you save for the future and have a retirement plan set up before you start investing in the stock markets. Don’t forget “retirement plans” are more than just a 401K; we’re also talking about 403Bs, 457s and other employee sponsored plans.)

Alright, now that's settled, let's get started.

What is Passive Investing?

Passive investing is when you purchase a (typically) diversified basket of stocks through an index or a few indexes ( i.e., a subset of the market) through a mutual fund or an exchange traded fund (ETF). Unlike active investing, when investing passively, an investor or manager is less focused on short term fluctuations in the market and thinks about their holdings more long term. Instead, investors use a buy-and-hold strategy in order to replicate the activity of the comparable market.

Through this method, the goal is to match the performance of the market you’re investing in. You’re not trying to beat it.

By owning many different stocks through an index fund, passive investors are simply aiming to earn the average return. This investing method is great for those looking for a less time consuming and long-term investment method.

Pros:

• More time efficient: Less research is required and you don't need to keep up with the latest market news. (Ahem, that means you can binge Netflix instead of stock reports on CNBC.)

• Less buying and selling: Again, with passive investing, we’re buying and holding. Not buying and selling. In other words, less work is needed and trading costs are generally lower.

• Tax efficiency: Because there is less buying and selling in passive investing, there are typically fewer capital gains to recognize.

• Transparency: The contents and current value of most market indexes are widely published, so you can see what is in them and easily verify pricing.

Cons:

• You're unlikely to substantially “beat” market returns: Passive investing is focused on achieving market returns. Therefore, you won't likely get above the index return.

• Not personal: Passive investments are typically limited to a smaller set of widely traded assets. This means it's harder to personalize, as strategy requires you do what the market does.

What is Active Investing?

Active investing is when (typically a manager, adviser or financial professional) attempts to beat the market’s performance (or that sector of the index market) by buying and selling positions in that market. Beating this benchmark is also known as Alpha return. Managers make these buying and selling decisions based on research, forecasting, experience and, well, a touch of personal opinion.

Pros:

• It can be possible to beat the comparable segment: Beating the market means you could make more of a return.

• Freedom: You don't need to hold certain stocks or bonds, meaning you have a larger variety from which to choose. Investors can also participate in more short-term trading opportunities.

• Risk management: Unlike passive investing, you don’t have to weather the storm when a holding drops. Instead, you can simply avoid or sell holdings.

• Taxes: With more control, an active strategy can include tax efficiency plays. For example, a tax-efficient manager may sell investments that are losing money to account for the taxes on holdings that are performing well.

Cons:

• It's hard to beat the market! Active investors typically own a smaller group of stocks and trade in and out of those stocks. Fewer stocks means you may put yourself at more risk if you were to pick the wrong one. When buying and selling more stocks, you put yourself at risk of trading at the wrong time. For those investing in an actively managed mutual fund or ETF, fund managers can buy whichever stocks they believe are going to have a good return on investment. While this can be profitable, you're at the mercy of your manager’s trajectory! So, if (s)he's wrong, you pay the consequences—literally!

• Requires more research: This may not be a con for those interested in the stock market but, in order to partake in active investing, you need to know your stuff.

• Fees: Active managers cost more than passive managers because they are doing more work and research. While you may have a higher ROI, you'll still have to account for paying their service fees.

Active or Passive Investing: Which method is most preferred?

Well, both. Passive investing has been gaining popularity; these funds are traded infrequently, have far lower management fees and are more tax advantageous. While some people favor passive investing because it’s less expensive and requires less attention, others trust active investing more because managers can add “alpha” (performance) from their research, forecasts and experience.

Keep in mind, too, that active management typically outperforms passive management during down markets. Historically, active managers have captured outperformance as the market recovers and passive management tends to outperform active during up markets.

Active or Passive Investing: What do the experts say?

In 2007, Warren Buffet added more fuel to the passive-or-active-investment debate when he made a $1,000,000 bet with a hedge fund saying that passive investing was better for the everyday investor.

That’s right: the world’s most famous active investor suggested passive investing for the majority of us. Why?

Because Buffett knows that index funds are inexpensive and not tied to the success of one single entity. He also knows that they will often outperform active managers who have to outperform the markets enough to make up for their fees, tax inefficiencies and emotional turmoil of their trades.

"The trick is not to pick the right company. The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently."

—Warren Buffett (CNBC)

Turns out Buffett won the bet and donated the $1,000,000 to charity (of course he did!)

So, which one is it?

Ultimately, the choice of active or passive investing is up to you. There’s no right or wrong investment strategy. It depends on your goals and how involved you plan to be in your investments.

Do you need help beginning to invest? We broke down the investment process into a few steps to help you get started! Or, are you already investing and might need to make some tweaks to your plan, given your current environment? We’re here to help coach you through it!