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- The goal of passive investing is to replicate the success of the market through assets like index funds.
- Active investing attempts to outperform the market with frequent, high-risk investing techniques.
- Passive investing strategies are more popular among retail investors and beginners.
Not all investors use the same investing strategies. Your approach to investing may depend on your financial goals and level of expertise.
New and more casual investors typically take the route of the passive investor who focuses on steadily building wealth over the long term with lower fees and less risk. More advanced and experienced investors, on the other hand, may prefer an active investing approach that capitalizes on short-term fluctuations in the market for the chance to hit the jackpot.
Here's how passive investing and active investing compare.
Passive vs. active investing
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What is passive investing?
Passive investing (aka passive management) is a low-cost, long-term investing strategy aimed at matching and growing with the market, rather than trying to outperform it. With passive investing, you must ignore the daily fluctuation of the stock market.
"At its heart, passive investing is a long-term investment approach where you buy a mix of stocks and bonds and other assets and hold onto them, regardless of market fluctuations," says Brent Weiss, CFP, cofounder, and head of financial wellness at Facet.
A buy-and-hold strategy is one of the most common and well-renowned passive investing techniques. Instead of timing the market and making frequent trades, a buy-and-hold strategy requires you to keep a cool head and maintain an optimistic outlook. By holding on to the same investments over time, you're improving the likelihood of earning a greater return down the line.
Advantages of passive investing
Lower risk
Passively managed funds invest in hundreds to thousands of different stocks, bonds, and other assets across the market for easy diversification. You're less susceptible to the ups and downs of the market since all of your money isn't invested in one basket.
Index funds are commonly used in passive investing strategies since they are generally low-cost and low-risk. Index funds are inherently diverse and are designed to track a certain area or broader sector of the market, such as emerging markets, large caps, or technology companies.
Lower fees
Index funds, such as low-cost ETFs or passively managed mutual funds, are affordable investment vehicles with lower management fees and reduced trading activity. Moreover, passive funds tend to be cheaper since they don't require nearly as much maintenance or research as active funds do.
"It's important to remember that when it comes to investing, it's not just how much you make but how much you keep that matters. Investing with low fees and paying less in taxes means more of your money is working for you," says Weiss.
Tax management
When you trade less, you pay less. You also won't experience nearly as many taxable events that would cost you down the line.
"Less buying and selling of investments means fewer taxable events like capital gains, and ultimately less taxes paid by investors along the way," says Weiss.
Beginner-friendly
Passive investors and beginners generally go hand-in-hand as more online brokerages offer managed portfolio options and robo-advisors with user-friendly interfaces.
Investing through a managed account is one of the best ways to expose yourself to the market without the risk of picking and choosing individual stocks and bonds. You'll also get access to goal-building tools and educational content like webinars and staking reward programs.
Potential for higher returns
Passive funds will often perform better and yield higher average returns compared to active funds. This is mainly due to the buy-and-hold strategy that allows investments to accumulate wealth over the long term. Although passive funds may underperform at some point in the market, this typically doesn't last very long.
Transparency
Passive funds tend to be transparent. Typically, you can tell what an index fund or ETF invests in simply through the name. For example, Vanguard S&P 500 ETF tracks the S&P 500 index, and the Fidelity ZERO Large Cap Index Fund tracks over 500 US large-cap stocks.
Disadvantages of passive investing
Limited investment opportunities and flexibility
Passive funds can be more limiting than actively managed funds. You'll mainly be tied down to index funds, which are comprised of predetermined investment options. Although there are passive funds that invest in more specific areas of the market, such as real estate or commodities, your options will be more limited.
Investors also toe the line of not being proactive in how they are investing their money.
"While passive investing makes sense for most people, it's still important to evolve your plan and your investments — how much you invest, the account you use, rebalancing, managing taxes, and adjusting risk," explains Weiss.
You have less flexibility in your investments. While this relieves you of the responsibility of selecting good investments, you won't be able to jump on any trendy investment opportunities. Similarly, when you invest in index funds, you're investing in all the assets involved with that fund. You won't have the flexibility to add or drop individual investments in that fund.
Potentially lower returns
The less risk you take, the less rewards you might receive. Passive funds rarely beat the market as they are designed to track it, not outperform it. You won't get the excitement of a single stock soaring in value.
What is active investing?
Active investing (aka active management) is an investing strategy used by hands-on, experienced investors who trade frequently. Unlike passive investing, which aims to match the market, active management's goal is to outperform the market.
Portfolio managers with professional expertise in economics, financial analysis, and the market often manage active funds. This professional management can be pricey, but thorough comprehension is necessary to know the best time to buy or sell a particular asset. You can technically actively manage funds yourself if you're equipped with the right knowledge — this just can be riskier than hiring a professional.
You can also invest in actively traded mutual funds and ETFs, which are pre-established investment portfolios based on market data and economic trends. But unlike passively managed funds, active funds are more volatile to the ups and downs of the market. For that reason, active investing is not the recommended strategy for long-term investing goals.
"It's important to note that research shows that people and fund managers do beat the market from time to time. However, the vast majority of investors do not consistently beat the market over long periods of time," says Weiss. "In reality, any edge they may create is often eliminated by the additional fees they charge, the trading costs they incur, and the higher taxes they create."
Advantages of active investing
Increased flexibility and trading options
Portfolio managers don't have to follow specific index funds or pre-set portfolios. Instead, active fund managers can pick and choose investments as they see fit and respond to real-time market conditions in order to beat short-term market benchmarks.
If you're considering managing your investment portfolio yourself, make sure you are equipped with a meticulous level of financial knowledge and economic expertise to not fall prey to the market's volatile nature.
Unlike robo-advisors, which mainly utilize the buy-and-hold philosophy to grow wealth in the long run, active investors can implement other trading strategies like shorting stock or hedging. Shorting stock is when an investor sells a stock shortly after buying it in the hope of re-buying it for a lower price. Hedging is a risk management strategy to protect investors against potential losses.
More tax-loss harvesting opportunities
Your portfolio manager may know the best method of executing trades to find more opportunities for tax loss harvesting and reduce your tax liability. Tax-loss harvesting is when you sell securities, like stocks or ETFs, at a loss to offset capital gains elsewhere in your investment portfolio. While some robo-advisors offer this feature, human advisors have the expertise and incentive to find more tax-loss harvesting opportunities.
Potential for higher returns
With higher risk comes a higher chance of reward. Although there's a greater chance that you'll lose your money by trying to outperform the market, the rewards can be astronomical if you succeed. Similar to gambling, the chance of hitting it big may be too tempting to pass up.
Disadvantages of active investing
Increased risk
Active investing attempts to benefit from short-term price fluctuations by implementing active trading strategies like short-selling and hedging. When active fund managers are successful, the returns can be great. But when they aren't successful, you could lose most if not all of your money.
Higher fees
Active fund managers tend to charge higher fees since this strategy requires a higher frequency of trading and more specialized expertise. Actively managed funds also have higher expense ratio fees (from 0.5% to 1.00%) compared to passively managed expense ratio fees (from 0% to 0.5%).
More taxable events
While you implement active investing strategies like short selling stock for capital gains, you may be subjected to more taxation. The extra money you've earned may end up being canceled out.
"Active investing creates more taxable events (e.g., capital gains) for investors, which means they will pay more in taxes along the way," says Weiss.
One exception, however, is tax-loss harvesting as it aims to lower your tax bill by offsetting capital gains with capital losses.
Passive vs. active investing — Frequently asked questions (FAQs)
Is it better to invest in active or passive funds?
When comparing active and passive funds, the best investment option for you depends on your personal preferences and goals. Passive funds are generally better for beginners and retail investors looking for low-cost assets with decreased risk. Active funds are better for experienced, hands-on investors who have market knowledge and don't mind the high risk.
What is the main difference between active and passive investing?
The main difference between active and passive investing is that active investing involves frequent trading in an attempt to outperform the stock market. Passive investing uses a buy-and-hold strategy to track the performance of the market.
What are examples of passive investing?
An example of passive investing is a robo-advisor. Robo-advisors are low-cost, beginner-friendly investment platforms that invest your funds in passively managed stocks, ETFs, and index funds.
Why is passive investing more popular?
Passive investing has increased in popularity with robo-advisors, such as Acorns, Wealthfront, and SoFi, which offer affordable, beginner-friendly interfaces for retail investors to access the market and learn about investing. Most robo-advisors have mobile trading platforms. Active investing is still popular among advanced traders seeking big returns on larger, riskier investments.
Which style of investing is best for you?
Between passive and active investing, the best investing style for you depends on your goals, risk tolerance, time horizon, and experience. Beginners are more suited for a passive strategy, such as investing in index funds and low-cost ETFs with a robo-advisor. However, more experienced investors with a higher risk tolerance may prefer the excitement and volatility of frequent trading on the daily market.
Weiss has experienced that active investing is often best for very specific situations, like private equity and venture capital.
"Active investing can make sense when there is a need to manage a very specific risk, challenge, or opportunity," he explains. "However, in general, most individual investors are best served by using passive investments as a component of a proactive personalized, and evolving investing strategy and financial plan to create long-term financial success."
But remember that you don't have to pick just one investing method. You can fund both passive and active funds. If you don't know how to get started, consider consulting a financial advisor for help creating a personalized financial plan.