Active investing may sound like a better approach than passive investing. After all, we tend to see active things as more powerful, more dynamic and more capable. Active and passive investing each have some positives and negatives, but the vast majority of investors will be best served by taking advantage of passive investing through an index fund.
This is why passive investing trumps active investing, and one hidden factor that keeps passive investors winning.
What is active investing?
Active investing is what you often see in movies and TV shows. It involves an analyst or trader identifying an undervalued stock, buying it and creating wealth from it. It’s true: There’s a lot of glamor in finding the undervalued needles in a haystack of stocks. But it takes analysis and insight, knowledge of the market and a lot of work, especially if you are a short-term trader.
Benefits of active investing
- You may achieve a higher return. If you’re skilled, you can earn higher returns by researching and investing in undervalued stocks than if you just bought a cross-section of the market using an index fund. But success requires expert knowledge of the market, and it can take years to develop.
- Fun to follow the market and test your skills. If you enjoy following the market as an active trader, then definitely spend your time doing so. However, you should realize that you will probably do better passively.
Disadvantages of active investing
- Hard to beat professional active traders. While active trading may seem simple — for example, identifying an undervalued stock on a chart seems easy — day traders are among the most consistent losers. That’s not surprising when faced with the powerful and fast automated trading algorithms that dominate the market today. The big money trades in the markets and has a lot of expertise.
- Most active traders don’t beat the market. It’s so hard to be an active trader that the benchmark for doing well is beating the market. It’s like par in golf, and you’ll do well if you beat that target consistently, but most don’t. A report from S&P Dow Jones Indices shows that about 60 percent of US fund managers investing in large companies underperformed their benchmark during the first six months of 2023. And the report found that underperformance rates tend to rise over time. These are professionals whose sole focus is to beat the market, ideally by as much as possible.
- It requires a lot of skill. If you are a highly skilled analyst or trader, you can make a lot of money with active investing. Unfortunately, almost no one is that skilled. Sure, some pros are, but even for them it’s hard to win year after year.
- Can result in a large tax bill. Although commissions on stocks and ETFs are now zero at major online brokers, active traders still have to pay taxes on their net profits, and heavy trading could lead to a huge bill on tax day.
- It takes a lot of time. Besides actually being difficult to do well, it actually takes a lot of time to be an active trader because of all the research you have to do. Therefore, it may not make sense to spend a lot of time on it if you don’t like it.
- Investors often buy and sell at the worst times. Due to human psychology, which is aimed at minimizing pain, active investors are not very good at buying and selling stocks. They tend to buy after the price has moved higher and sell after it has already fallen.
What is passive investing?
Passive investing, on the other hand, involves a long-term buy-and-hold approach, typically by purchasing an index fund. Passive investing using an index fund avoids analyzing individual stocks and trading in and out of the market. The goal of these passive investors is to achieve the return of the index, rather than trying to outperform the index.
Benefits of passive investing
- Beats most investors over time. Passive investors try to ‘be the market’ rather than beat the market. They would prefer to own the market through an index fund, and by definition they will receive the returns of the market. For the S&P 500, that average annual return over a long period of time is about 10 percent. By owning an index fund, passive investors essentially become what active investors try (and usually fail) to beat.
- Easier to succeed. Passive investing is much simpler than active investing. When you invest in index funds, you don’t have to do any research, pick the individual stocks, or do any other legwork. Now that low-fee mutual funds and exchange-traded funds are a reality, it’s easier than ever to be a passive investor, and it’s the approach recommended by legendary investor Warren Buffett.
- Deferred capital gains tax. Buy-and-hold investors can defer capital gains taxes until they sell, so they don’t have to pay much tax in a given year.
- Requires minimal time. At best, passive investors can look at their investments for 15 to 20 minutes each year at tax time and otherwise be done with investing. So you have the free time to do what you want, instead of worrying about investing.
- Let the success of a company determine your return. When you invest with a buy-and-hold mentality, your returns over time are determined by the success of the underlying company, not your ability to outsmart other traders.
Disadvantages of passive investing
- You get an “average” return. If you buy a collection of stocks through an index fund, you will earn the weighted average return of those investments. In the meantime, you’d do much better if you could identify the best performing products and buy only those. But over time, the vast majority of investors – more than 90 percent – cannot beat the market. So the average return is not that average.
- You still need to know what you own. When you actively invest, you know what you own and you need to know the risks each investment is exposed to. With passive investing, you also need to broadly understand what any funds are investing in so that you don’t pull out completely.
- You may be slow to respond to risks. If you take a long-term approach to your investments, you may be slower to respond to real risks to your portfolio.
Active versus passive investing: which strategy should you choose?
The trading strategy that is likely to work better for you depends a lot on how much time you want to spend investing, and honestly, whether you want the best chances of success over time.
When active investing is better for you:
- You want to spend time investing and you enjoy doing so.
- You love research and the challenge of outsmarting millions of smart investors.
- You don’t mind underperforming, especially in a given year, if you’re seeking investing mastery or even just enjoying yourself.
- You want a chance at the best possible return in a given year, even if it means significantly underperforming.
When passive investing is better for you:
- You want a good return in the long term and are willing to give up the chance of the best return in a given year.
- You want to beat most investors, even the pros, over time.
- You love and feel comfortable investing in index funds.
- You don’t want to spend a lot of time investing.
- You want to minimize taxes in a given year.
Of course it is possible to use both approaches in one portfolio. For example, you can keep 90 percent of your portfolio in a buy-and-hold approach with index funds, while the rest can be invested in a few stocks that you actively trade. You get most of the benefits of the passive approach, with some stimulation from the active approach. You’ll end up spending more time actively investing, but you don’t have to spend that much more time.
The easy way to make passive investing work for you
One of the most popular indexes is the Standard & Poor’s 500, a collection of hundreds of top American companies. Other well-known indexes are the Dow Jones Industrial Average and the Nasdaq Composite. Hundreds of other indexes exist, and each industry and subsector has an index made up of the stocks within it. An index fund – whether an exchange-traded fund or a mutual fund – can be a quick way to buy the sector.
Exchange traded funds are a great option for investors who want to take advantage of passive investing. The best ones have super low expense ratios, which are the fees investors pay for managing the fund. And this is a hidden key to their outperformance.
ETFs generally attempt to match, rather than beat, the performance of a specific stock index. This means that the fund simply mechanically replicates the investments in the index, whatever they are. The fund companies therefore do not pay for expensive analysts and portfolio managers.
What does that mean to you? Some of the cheapest funds will charge you less than $10 per year for every $10,000 you invest in the ETF. That’s incredibly cheap for the benefits of an index fund, including diversification, which can increase your returns and reduce your risk.
Mutual funds, on the other hand, tend to be more active investors. The fund company pays managers and analysts a lot of money to try to beat the market. That results in high expense ratios, even though fees have been on a long-term downward trend for at least the past few decades.
However, not all mutual funds are actively traded and the cheapest ones use passive investing. These funds are cost competitive with ETFs, if not cheaper in quite a few cases. Fidelity Investments even offers four mutual funds that don’t charge you any management fees.
Passive investing also performs better because it is simply cheaper for investors.
In short
Passive investing can be a big winner for investors: it not only offers lower costs, but also outperforms most active investors, especially over time. You may already be making passive investments through an employer-sponsored retirement plan, such as a 401(k). If not, this is one of the easiest ways to get started and enjoy the benefits of passive investing.
