Active vs. Passive Investing: Differences and Strategies
Passive investing tends to be quicker and easier, and deliver better overall returns
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The main difference between active investing and passive investing is that active investing involves frequent buying and selling with the intent to beat market averages, whereas passive investing typically involves holding investments for a relatively long time with the objective of matching the performance of a market index. Passive investing strategies often have higher returns than active strategies and cost less.
How active and passive investing work
Active investors research and follow companies, industries, news and markets closely, and they buy and sell based on market movements or their view of the future. This is a typical approach for professionals or those who can devote a lot of time to research and trading.
Passive investors buy a basket of securities and add to their portfolios more or less regularly, regardless of how the market is faring. This approach requires a long-term mindset that disregards the market’s daily fluctuations.
Mutual funds and exchange-traded funds can take an active or passive approach.
Active fund managers may buy and sell every day based on their research, trying to ferret out investments that can beat market averages.
Passive fund managers are content to be the market average, hitching themselves to a preset index of investments, such as the Standard & Poor’s 500 index or others.
Passive funds tend to buy and sell mechanically, which means they typically have lower expense ratios. Those lower costs are another factor in the better returns for passive investors.
Investors can mix and match their approaches.
They can be active traders of passive funds, betting on the rise and fall of the market, rather than buying and holding like a true passive investor.
Conversely, they can passively hold actively managed funds, expecting that a good money manager can beat the market over time.
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Is it better to be an active or passive investor?
The vast majority of active fund managers underperform the market benchmark they're trying to beat. Even when actively managed funds do experience a period of outperformance, it doesn't tend to last long. With so many pros swinging and missing, many individual investors opt for passive investment funds made up of a preset index of stocks or other securities.
To get the market’s long-term return, passive investors often have to hold their positions for a relatively long time (and ideally add to their portfolios regularly).
Active investors rarely outperform the market. Often, this is because investors may be tempted to:
Sell after their investments have gone down in value.
Buy after their investments have gone up in value.
Stop buying after the market has declined.
» MORE: How to invest $100,000
Pros and cons of passive investing
Lower cost.
Tends to outperform active investing.
May mitigate some risk.
Requires patience.
May miss short-term run-ups in specific securities.
Pros and cons of active investing
May participate in run-ups of specific securities.
Higher cost and time commitment.
May not outperform market.
Risk.
Types of passive investments
Funds built on the S&P 500 index, which mostly tracks the largest American companies, are among the most popular passive investments. If they buy and hold, investors may earn close to the market’s long-term average return and may beat professional investors for less effort and at lower cost.
Index funds can be constructed around many categories. For example, there are indexes composed of medium-sized and small companies. Other funds are categorized by industry, geography or almost any other popular niche, such as socially responsible companies or “green” companies.
While some passive investors like to pick funds themselves, many have their financial advisors or automated robo-advisors build and manage their portfolios. Many advisors use low-cost ETFs to keep expenses down.