One of the primary decisions in investing is whether to be a passive investor, an active investor, or a combination of both. The chosen path will impact performance, the time spent managing money, and even the level of stress involved in the process. This is not a decision solely for new investors. Even experienced investors should periodically reevaluate whether their choice is still the best option to suit their requirements.
Let’s build a framework around passive and active investing, enabling investors of all experience levels to make informed decisions that fit their needs.
Top Forex Brokers
Introduction to Passive & Active Investing
Let’s first define the terms “passive investing” and “active investing.”
What is Passive Investing
In simple terms, passive investing means following or mirroring the market’s value. How do I do that? Let’s take an example. If I want to be a passive investor in the U.S. stock market, I can invest in an instrument that tracks an “index” of the U.S. stock market. An “index” is simply a combined value of a collection of securities. Because passive investing mirrors the value of an index, it’s also known as “index investing.”
For the U.S. stock market, the most widely followed index is the S&P 500, which tracks the combined value of the 500 largest publicly traded U.S. companies. For example, I can purchase an instrument that mirrors the value of the S&P 500. A popular method to do this is through buying units of an “Exchange Traded Fund” or ETF, which can track or mirror an entire index’s value, but trades as if it were a single share. Most ETFs are passive, but some are active.
Nearly every market has an index that measures its value. For example, the UK stock market has the FTSE 100 index, which tracks the combined value of the largest 100 stocks traded on the London Stock Exchange. The U.S. stock market has several other indices in addition to the S&P 500, including the Dow Jones Industrial Average (DJIA) and the Nasdaq 100.
What is Active Investing
Every feature of passive investing is the opposite of active investing. For example, if I am an active investor in the U.S. stock market, I will decide which individual stocks to trade rather than mirroring a market’s value. I may trade just a handful of companies or hundreds of companies. I may focus on specific sectors, e.g., AI, technology, or pharmaceuticals and exclude other sectors, such as transportation. In contrast, passive investing involves investing in all the components of the index. In active investing, I can also buy and sell specific stocks at different times, depending on my view of how I think they will perform.
Ultimately, active investors believe they can outperform the growth of the indices.
Active investors should measure their returns against the markets in which they trade. If I were a US equities investor, I would measure my performance against the S&P 500 or a similar benchmark. For example, if I achieved a 15% growth in one year, and the S&P 500 grew by 10%, I have outperformed the market by 5 percentage points. However, if I achieved 8% growth, even though I have not lost money, I have underperformed the index by 2 percentage points.
Passive vs. Active Investing — Key Differences
- Passive investing mirrors the value of a market as tracked by an index, such as the S&P 500 U.S. equity index. Active investors aim to outperform the index; however, they may actually underperform.
- Passive investing does not involve selecting which securities to buy and sell. In contrast, active investing involves selecting which securities to buy and sell, and, just as importantly, determining when to buy and sell them.
- Passive investing will have the same returns as the index. If the value of the S&P 500 rises by 10%, an S&P 500 passive or index fund will also rise by 10%. Whereas active investors' returns will depend on the decisions they make.
- Passive investing has become low-cost, especially with the introduction of Exchange Traded Funds or ETFs, which allow investors to trade indices as if they were single shares. In contrast, active investing has the potential to incur higher trading costs (e.g., brokers’ commissions and spreads) because it can involve more frequent buying and selling compared to a passive fund.
- Active investing requires more time to implement than passive investing, because it means researching which securities to buy and sell, and executing those trades individually.
- Many indices have been in existence for decades, giving passive investing a long track record. For example, the S&P 500 has a nearly 70-year track record. That means it has been tested across many different economic and political environments. A long track record also enables investors to easily view the average annual growth and the duration of downturns before recovery.
- Passive investing generally only involves long positions. Active investors can take short positions, trade derivatives such as options, and often have access to greater trading leverage, allowing them to capitalize on varying market conditions.
Passive vs. Active Investing—Pros & Cons
There are plusses and minuses to each of these two investment approaches and your choice will depend on a variety of factors, such as the time you have available to commit to investing, your psychological makeup, your experience level, financial capacity, risk tolerance and more.
The Pros of Passive Investing
- Low cost, e.g., under 1% management fees for passive ETFs
- Passive investing requires a low time commitment
- Instant diversification across broad markets, e.g., 500 stocks across multiple sectors in the S&P 500
- It's easy to start passively investing in any market with products such as ETFs
- Many indices have long track record for investors to gauge future performance
The Cons of Passive Investing
- Most passive funds are long-only
- Leverage is often not available for passive funds
- Returns are limited to the index’s performance
- Passive investors must sit through the entire length of negative market trends
The Pros of Active Investing
- Potential to outperform the markets
- Ability to take long or short positions to capitalize on different trend directions
- There's greater flexibility for leverage
- There's the ability to use derivatives, such as options, to capitalize on different market conditions
- It is easier to be a contrarian investor as an active investor
- Investors can buy or sell certain securities to minimize taxes
The Cons of Active Investing
- Potentially higher trading costs compared to passive funds
- Takes more time to learn to be a good active investor
- It takes more time to actively invest
- There's the risk of underperforming the market or benchmark even after all your efforts
- It is easier to be subject to emotional trading as an active investor
Which Investing Approach is Right for You?
For me, finding the correct approach comes down to two primary factors: time and knowledge. If I want to actively trade a market, I have to ask myself if I have the knowledge to outperform the index. Second, do I have the time to actively trade? I must be as certain as possible in answering these two questions to pursue active trading. Remember, with the increase in potential returns in active trading, there is also an increase in potential risk, especially when leverage is involved. There are plenty of individuals who have blown out their accounts as active traders. However, nobody has ever blown out an account by investing in a well-established index, such as the S&P 500.
Passive investing generally has slower growth than active investing, but passive investing's growth can often be steadier. For example, I have built a substantial nest egg over the last fifteen years by investing a portion of my savings and income in an S&P 500 equity index fund with low fees, allowing it to grow steadily over time. I’ve not had to think about it or manage it in any other way, and today, it’s become a significant part of my net worth. I have such confidence in this approach to managing part of my savings that I will encourage my children to adopt the same strategy.
Active investing also enables individuals to time the buying and selling of individual stocks to minimize their tax liability.
Passive and active investing are not mutually exclusive decisions. I believe everyone should allocate a portion of their savings and income to a passive equity fund, particularly the S&P 500, due to its uniquely long and durable track record. And then, if they feel qualified to actively invest, they can pursue that with additional capital.
There is a third option: to invest in an active fund rather than being an active investor. However, active funds typically have higher fees than passive funds, and investors should take this into consideration when comparing returns.
Bottom Line
Deciding whether to be a passive or active investor is one of the most crucial decisions an individual can make regarding their investment capital. Passive investing is easier, low-cost, and I believe all investors should consider it for a portion of their long-term savings. Active investing can offer higher returns, but it also carries higher risks and requires more time and expertise to execute successfully. Actively managed funds offer a third option for investors seeking exposure to active investing, but who lack the time or knowledge to carry it out.
