Today we will introduce you to two main approaches to investing – passive vs. active investing strategy.
An investor with a passive strategy will devote less time to the market and can increase capital at a pace in line with the markets less a small management fee.
Opposite, an active investing strategy implies greater involvement in the process. You can earn more, but risk failing to beat the indexes (like most active investors do).
Related reading: – Looking for an investment strategy? (We have hundreds)
Let’s look at everything in order: Passive vs. active investing strategy.
What Is Passive Investing?
Passive investing allows the investor to save energy, hassle, and time. It requires only minimal knowledge of the market. A passive investing strategy is a “buy and hold” approach. You buy and “forget” about it and let time do the compounding.
Perhaps ironically, the less you do, the better you’ll probably do. Research suggests that the more active you are, the worse you do. Women have proven to be better investors than men, which happens because women are not trying to be smart. They buy and do nothing.
The main goal of a passive investment strategy is to earn returns above inflation, and get returns in line with the broad market. The investor tries to ensure that his money does not depreciate and that the investments bring about as much income as the general market allows.
The easiest way to achieve this is to invest in index funds. The passive investor does not dive into analysis of individual stocks or markets, and he or she is certainly not trying to time the market. The passive investor simply buys a stake in an exchange-traded fund (or mutual fund) in one transaction and lets the money work for the long term. It’s a very simple investment proposition. Most passive investors do dollar-cost averaging.
A typical example is buying a fund that mimics the performance of the S&P 500. For example, you can invest in the SPDR S&P 500 ETF Trust (SPY). One “share” of this fund is worth about $441 in June 2023.
In SPY, for this amount, the investor gets a balanced portfolio of stocks of the 500 largest US companies. And a professional team will manage these assets – the investor does not need to monitor the portfolio’s composition, or buy or sell stocks if the index structure changes. Perhaps the best part is that the expense ratio is only 0.09% annually. This is much less than the typical 0.75% or more for an actively managed fund.
He or she can hold a stake in the fund for years, and the investment will grow along with the entire market – in this case, the S&P 500 index.
Also, passive investing involves investing in funds that track sectors of the economy – technological, energy, industrial, or others. There are plenty of passive ETFs and funds.
One of the main conditions for successful passive investing is diversification. It is more important for a passive investor to distribute funds among a wide basket of assets than to “guess” the most profitable ideas. And time is essential. The longer you are invested, the more you make (as a rule of thumb). Please read our article about the three most important factors to compound efficiently.
What Is Active Investing?
An “aggressive” or active investing strategy or approach assumes that the investor constantly manages the funds: he monitors the market, news, performance, analyzes companies, and selects securities and the timing of transactions.
Active investing is more suitable for experienced investors and traders. As an active investor you need to know technical or fundamental analysis, have a good command of the trading platform, and have skills in risk management and money management.
The main goal of active investing is to earn a return at least the level of the market, or, if possible, to “beat” it. In short, an active investor tries to outperform his benchmark.
Because of the focus on high returns, the aggressive investor’s portfolio is highly likely more concentrated. It will have fewer instruments (stocks), and the assets might be tilted toward specific sectors of the market.
An active investor selects individual securities. Often these are stocks of fast-growing companies, or it might involve sector rotation. The main idea is that he or she deviates from a passive index that is the benchmark. To beat the index, it has to be done differently.
The time horizon of the active investor is shorter. Some active investors might even be more like traders, like, for example, Bill Ackman. Traders can use strategies in which transactions last a few minutes or several months.
If a passive investor can hold securities for years and ride out even major market downturns, this is less unacceptable for an active investor. It is important for him or her to capture price trends and extract the maximum opportunities in the market.
Also, an aggressive investor can use more advanced methods – open short positions (make money on falling prices), and apply option contracts and other derivative financial instruments.
Fund or ETFs that are actively managed usually charges more in management fees. A typical mutual fund might charge at least 0.75% annually. Recovering this cost over time is very difficult; thus, most active investing strategies fail to beat the market.
Berkshire Hathaway is an example of an active investor and probably needs no introduction. We might argue that Berkshire Hathaway is a mutual fund. It’s a diverse company, and the management fee is very low. A Swedish version of a somewhat similar business model is Investor AB. Total costs are 0.11% of the assets, and Investor AB has outperformed for over 100 years (Investor AB analysis).
Advantages Of Passive Investing
Let’s look at the pros and advantages of passive investing:
- Savings on commissions and taxes. An index investor pays no commission for buying and selling each security. He receives and sells them all in a single basket at the price of one transaction (except for a small transaction fee if investing in ETFs). Also, with a long-term holding of securities, the investor will pay taxes only on any dividends received. As long as the positions are not sold, no taxes on capital gains are paid because capital gains are deferred to the moment of realization. You still might need to file a tax return every year.
- Easy access for beginners. Buying a share in a mutual fund or ETF is enough to open a brokerage account without understanding much about the trading platform or ask for help from an employee of an investment company. You do not need to understand the stock market and know complex analysis methods deeply. You buy and forget about it.
- Participate in the most profitable opportunities. Fund portfolios are widely diversified. When an investor buys a fund, he or she takes part in the growth of all/many companies at once. Of course, each share is small, and the ownership is not concentrated, but it’s still better than staying on the sidelines and missing out on opportunities. Time is a friend of compounding and returns.
- The risks are lower. Individual stocks usually fall much more than the broad market, and the majority of stocks fail. Think back to the early 2000s. Then there was an extreme situation – the “dot-com crisis”. The NASDAQ fell 78% in two years, and the S&P 500 fell 50%. At the same time, stocks of such giants as Cisco or Amazon lost 90-95% in their value! Interestingly, the S&P 500 fell much less than the NASDAQ. This happened because the S&P 500 includes more companies from various sectors and industries of the economy. But the NASDAQ was more focused on Internet startups and technology projects. Conclusion: it is safer to invest in more diversified portfolios.
- It can be combined with employment. A passive portfolio can be left untouched for years. And even if the investor has diversified funds well among many stocks, he may also revise such a portfolio infrequently. You can set aside a couple of hours for this every three months. For the passive investor, the cycle is typically like this: Work, save, invest, and forget about it. When you want to withdraw money, you can make automatic withdrawals every month; thus, there are no decisions to make.
- Less speculative. When a person rarely watches the market, he is less tempted to get involved in some “hot story” or start gambling. Also, we believe passive investors are less susceptible to cognitive investment mistakes and biases.
Disadvantages Of Passive Investing
Let’s look at the cons and disadvantages of passive investing:
- Fewer high-return opportunities. Hundreds of high-growth companies are not included in stock indexes. If an investor has invested in an index fund, he will not have many stocks in his portfolio that could bring good returns. Indices also do not include initial public offerings (IPOs), that sometimes explode in price to the upside (although, as a group IPOs are a poor investment). But do not be discouraged; you can do both passive and investing simultaneously. If desired, an investor can own a passive portfolio and allocate a small part of the capital for more risky ideas to (hopefully) increase the overall return of their investments.
- Little flexibility. Investing in funds takes away the ability to choose companies on your own. This can play against the investor in different ways. One of the options is this: suppose an investor, for ethical or religious reasons, does not want to invest in tobacco, alcohol, or arms producers. But, if the stocks of such a company are part of the fund, the investor will not be able to exclude them.
- Inaction during market downturns. When market prices decline a lot, the passive investor sits out these corrections. As a result, he can see possible losses on his account for months. Not everyone can endure such psychological pressure from losses. On the other hand, an investor can buy more securities after a drop in share prices. The latter is dollar cost averaging and is explained here. If you are a future net buyer of stocks, you’d welcome a bear market. After all, you want to buy low and sell high – not the opposite.
Advantages Of Active Investing
Let’s look at the pros and advantages of active investing:
- Unlimited profit potential. Stocks in the stock market can bring hundreds and even thousands of percent returns. If an investor knows how to find and work out such opportunities, he will be able to multiply his capital many times over. Take the famous trader Larry Williams. In 1987, he turned $10,000 into $1,100,000! And his story is not the only one – there are other traders around the world who made millions in the markets. Of course, only a few can boast of such achievements, but it is still possible, but we sometimes fool ourselves due to survivorship bias. How do you find multibagger stocks?
- Flexibility. Active investments give you a choice of dozens of financial instruments, thousands of securities, and unlimited investment strategies.
- Opportunity to turn investments into your core business or employment. If you make a lot of money investing, why should you look for employment elsewhere? It’s a great job if you are successful.
Disadvantages Of Active Investing
Let’s look at the cons and disadvantages:
- Lots of fees and taxes. The more transactions, the more costs. If you don’t have a tax-deferred account, taxes might ruin your compounding.
- Higher risks. On the stock exchange, high returns usually involve high risk. If you do poorly, you lose one of the main benefits of investing: time. You risk wasting your time.
- It’s complicated. You need to understand charts, financial statements, news, economics, technology trends, etc. You need to develop a specific business plan to be successful.
- Most investors fail to beat the indices. At the end of the day, the sad truth is that the great majority of investors fail to beat the averages.
Which strategy works best and which one to choose
Let’s say right away that most investors are advised to compile a high-quality passive portfolio, and only then, if they wish, allocate a small part of the capital for high-yield instruments. You can also buy more securities for a passive portfolio during market downturns.
Generally, it is best to use a passive strategy with small elements of an active one (or even no active investing).
Why is that? First, active portfolio management or trading requires much knowledge and skills. And it takes a lot of time to analyze the market. It is challenging and not suitable for everyone.
Second, consider this uninspiring statistic: according to the latest SPIVA report from the S&P Global agency, over a 20-year horizon, only 3.27% of fund managers in the United States managed to outperform S&P 500 index. That is, 96.73% of managers failed to beat the broader market!
The pie charts below show the percentage of active U.S. equity funds that underperformed their respective benchmarks for the 20-year period ended Dec. 31, 2022:
The pie charts below show the percentage of active bond funds that underperformed respective benchmarks for the 15-year period ended Dec. 31, 2022:
In this case, we are talking about investment professionals who have devoted their entire professional life to the securities market. They have access to expensive analytical resources, many of them physically work on Wall Street, they graduated from Ivy League universities… And despite all this, it is difficult for professional managers to stay ahead of the benchmark in the long term. So why do you think you can do it?
Of course, everyone decides for himself. But, if the S&P 500 index can bring better results in the long run, and there is an opportunity to invest in it without much time and effort, a passive investing strategy is definitely worth considering.
Passive vs. Active Investing Strategy – Which One To Choose – conclusion
We have already concluded in the section above, but let’s repeat:
Let’s say right away that most investors are advised to compile a high-quality passive portfolio, and only then, if they wish, allocate a small part of the capital for high-yield instruments.
The great majority of investors should choose a passive investment strategy.