Is Active or Passive Investing Best? What's the Difference and Pros & Cons

By Myles Leva

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Last Updated: September 1, 2022

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Generally speaking, passive investing is the route you will probably take.

If you invest in index funds (or other mutual funds), you’re already engaged in passive investing. The same goes if you invest in ETFs.

Despite this, it can be useful to understand the difference between passive and active investing. In this article, we will cover what exactly these two terms mean. We will go over some misconceptions about their definitions, and share some examples and expected results that each produces.

 

 

What is Active and Passive Trading?

Active Trading

Active investing is the “hands-on” approach to investing. It requires that you either:

  • Outsource your portfolio management to a direct portfolio manager or other active investing participant
  • Conduct your own trading activity in the role of your own portfolio manager

What sets active trading apart from passive investing is that active trading requires direct attention from one active participant towards a single portfolio. However, portfolio managers normally have a team behind them, so “active participant” doesn’t imply a single expert making all the decisions.

The main reason people choose active trading over the passive alternative is to try to beat the market. In theory, an active, deliberate strategy with deeper analysis should lead to better returns.

The ability of active portfolio managers to take advantage of short-term fluctuations is another advantage. Instead of just tracking an index, the manager can act proactively and take advantage of a variety of opportunities as they pop up.

 

Passive Investing

Passive investing is the “hands-off” option.

Your investments are made deliberately for a very long period. You limit the amount of buying and selling going on and maintain a “buy and hold” strategy.

Passive investing has some major benefits. First of all, it’s cost-efficient.

Transactions cost money, and when you’re investing passively, you make less of them. It’s also time-efficient; you spend less time analyzing and don’t have to concern yourself with short-term opportunities that pop up, as you’re seeking long-term value.

 

 

Which is an example of passive investing?

The best example of passive investing is any kind of successful index fund.

An index fund that tracks an index such as the S&P 500 may have hiccups when downturns occur, but over any longer stretch of time, it’s a relatively safe bet.

While the S&P 500 has dropped significantly during certain years, the long-term returns are strong. During the past 20 years, the average return was roughly 10%, without taking inflation into account.

Index fund returns are aligned with overall market returns. So, you won’t beat the market, but you don’t need to invest nearly as much time into research and you don’t need to take the risk that active investing implies.

 

 

Does active trading beat passive trading?

Most of the time, no.

Active investing does offer a great advantage: flexibility when it counts, such as when the market is highly volatile. But this doesn’t necessarily translate to higher returns. There are a few reasons for this.

 

Costs

Active trading requires much more dedicated work from professionals.

The time spend on analysis is an overhead cost that cuts into profits. At the same time, there are more trades, meaning more fees. Overall, active trading has a higher expense ratio.

 

Returns

In addition, it’s hard to calculate the average returns for all actively managed portfolios. To be more profitable than their passive counterparts, the returns would need to be high enough to also account for the higher expense ratio.

Passive investors often hold to an idea of average 10% annual returns. This roughly aligns with market performance. The fact of the matter is that most professional traders do not beat that.

Of course, the exception here is indeed the exceptional actively managed portfolios that do beat the market. The benchmark here would be regular annual returns exceeding 10%.

Some people, such as Warren Buffett, have well exceeded that rate for extended periods, such as when Buffett achieved a 30% annual return for over a decade.

The Oracle of Omaha has in fact regularly beaten the Dow Jones. Others also have impressive records in active investing. However, they are of course in a small minority.

 

 

Is passive investing better than active?

When this inevitable question pops, it would seem that the only fair answer is “in the vast majority of cases, yes”.

If you’ve figured out a strategy like Peter Lynch or Warren Buffett and can beat the market, that’s great. In fact, understanding their investment philosophies can help you understand the market more broadly.

But the reality is that most actively managed portfolios don’t do nearly as well. Buffett himself recommends sticking with a reliable index fund that tracks the S&P 500.

 

 

Conclusions

Passive investing isn’t necessarily better than active investing, but it usually produces better results.

But in both cases, research is required to determine whether you want to invest in a certain index or hire a certain active manager. But for most people, passive investing in the right kind of index fund is the both the path of least resistance and the path to the best returns. It takes special talent to beat that.

Photo by Michael Burrows

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