Active vs. Passive Investing: Differences Compared
Passive investing tends to be quicker and easier, and deliver better overall returns
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The news has been the same for over a decade: More money is flowing out of actively managed investment funds and into passively managed funds.
What is the difference between active and passive investing?
The biggest difference between active investing and passive investing is that active investing involves a fund manager picking and choosing investments, whereas passive investing typically tracks an existing group of investments called an index. Passive investing strategies often perform better than active strategies and cost less.
Understanding active and passive investing
Active investors research and follow companies closely, and they buy and sell based on 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 buy 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.
Similarly, mutual funds and exchange-traded funds can take an active or passive approach.
Active fund managers buy and sell every day based on their research, trying to ferret out investments that can beat the 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.
And investors can mix and match. 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, passive investors can hold actively managed funds, expecting that a good money manager can beat the market.
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Is it better to be an active or passive investor?
Despite the fact that they put a lot of effort into it, the vast majority of 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 have opted for passive investment funds made up of a preset index of stocks or other securities.
» Prefer the passive approach? See our picks for top robo-advisors
Passive investing tends to be cheaper
Passive funds buy and sell mechanically. Investors in passive funds are paying for computers and software to move money, rather than a high-priced professional. So, passive funds typically have lower expense ratios, or the annual cost to own a piece of the fund. Those lower costs are another factor in the better returns for passive investors.
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 — historically about 10% annually — meaning they might beat professional investors but with less effort and lower cost. An active fund manager's experience can translate into higher returns, but passive investing, even by novice investors, may beat all but the top players.
That hardly sounds like “settling” for a passive approach. In fact, billionaire investor Warren Buffett recommended buying low-cost S&P 500 index funds.
While S&P 500 index funds are popular, 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.
For passive investing to work, you have to stay invested
To get the market’s long-term return, passive investors often have to actually stay passive and hold their positions (and ideally add more money to their portfolios at regular intervals).
Even active fund managers whose job is to outperform the market, rarely outperform the market. It's unlikely that an amateur investor, with fewer resources and less time, will do better.
For most investors, the first step toward being active can take a bite out of their potential returns. Investors are tempted to:
Sell after their investments have gone down in value.
Buy after their investments have gone up in value.
Stop buying funds after the market has declined.
» MORE: How to invest $100,000
