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Updated on Tuesday, November 24, 2020
When it comes to investing, there are two broad approaches: active vs. passive. An active investor is looking to buy and sell investments in order to earn a higher return than the market average. A passive investor does not make many trades and instead buys funds that try to match the average market return.
In this article, we look at the key differences between active vs. passive investing so you can decide which approach makes sense for you and your portfolio.
- What is active investing?
- What is passive investing?
- Differences between active investing and passive investing
- Should you choose active investing or passive investing?
What is active investing?
An active investor tries to earn an above-average return. They might measure their performance against a market benchmark such as the S&P 500, a listing of the stocks of 500 large publicly traded companies in the United States.
An active investor would research the 500 companies on this list, and other companies (for example, smaller or mid-size companies that would not be in the S&P 500) and try to buy the individual stocks they think have the best chance for high gains. They may also reevaluate their decisions regularly and sell investments they no longer think are good picks — or buy new investments that catch their interest.
Active investing is more hands-on and requires more research. Active investors may also use more high-risk, high-return trades, such as:
- Trading options (making bets on an asset’s future performance through buying a contract to buy or sell it at a specified price and date)
- Selling stocks short (essentially, betting that the stocks will lose value)
- Buying stock on margin (borrowing money to buy a stock)
Active investors also may buy funds that are actively invested by money managers. Whatever approach they take, active investors are constantly looking for opportunities to make a profit.
Given the challenges and extra work involved, the approach is best for more sophisticated investors who want to be very involved in researching their portfolio.
Pros of active investing
- Chance for high returns: If your trades work out, you could potentially earn a return above the market average.
- Flexibility to design your own portfolio: As an active investor, you decide which stocks, bonds and other investments go into your portfolio. You aren’t forced to hold investments you don’t like.
- Could reduce losses during market downturns: If you worry some parts of your portfolio or even the entire market will crash, you might sell your investments off ahead of time, or you may make money by shorting stocks.
- Adds more fun to investing: When your investment picks beat the market, you get the bragging rights and the pride of seeing your hard work pay off.
Cons of active investing
- Higher fees: One downside of active investing is that there are generally higher fees than there are for passive investing. Each investment trade may involve fees, such as brokerage commissions and fund load fees, although an increasing amount of brokerages allow for $0 commission trades. Still, because an active investor is making more trades, they will end up paying more of any fees there are. If you hire an active portfolio manager, you’ll also pay a fee.
- Higher taxes: Taxes can also be higher when you are actively trading. Whenever you sell an asset for a gain, you could owe capital gains on the profit, and you pay more for short-term capital gains (that is, for an investment sold before you’ve held it for a year). As a result, active investors not only need to make trades that outperform the market, they also need to outperform the market by enough to overcome extra taxes and fees.
- Risk of a large loss: If your trades don’t work out, you could face significant losses, especially if you use high-risk strategies.
- Takes more work: You need to research your trades and constantly keep up with market news to decide when it’s time to buy and sell investments. Not paying attention could cost you.
- No guarantee your research will pay off: Beating the market is extremely difficult and even many professional investors fail to do so. With active investing, it’s possible you will put in a lot of extra work without seeing any extra benefit.
What is passive investing?
With passive investing, you aren’t trying to identify the best investments to beat the market. Instead, you invest your portfolio to match the return of a market benchmark, such as the S&P 500. There are index mutual funds and exchange-traded funds that track these benchmarks to deliver that return for your portfolio.
This takes much less work and the returns can still be quite reasonable. For example, from 1937 through 2019, the average annual return of the S&P 500 was around 10%. Of course, during a shorter period, you may get a return much lower — or higher — than that. You also have to keep in mind that past market performance is not necessarily indicative of future results.
With this approach, you also trade less frequently and aren’t constantly replacing investments. It’s more of a buy and hold, long-term strategy.
Since you’re making fewer trades with passive investing, you should owe less for investment fees. Passive investment managers also charge less than active managers. In addition, because you aren’t selling your funds for a gain as often, you should minimize your capital gains taxes.
Passive investing is commonly used by less sophisticated investors as well as those who don’t want to put in lots of work managing their portfolios. It’s a simpler way to earn a steady, long-term return.
Pros of passive investing
- Much easier to manage: With passive investing, you don’t have to deeply research your investments or follow daily market news for trades. You just figure out the market benchmarks you want, buy them and then aim to grow your money long-term.
- A steady, long-term return with less risk: The average long-term market return is decent, and may be even better than what professional investors make. Nonprofessional investors also typically underperform the market, so by following a passive approach, you might end up doing better in the long term.
- Lower fees and taxes: Since you aren’t trading much with a passive investing approach, you minimize trading fees. You also will reduce what you owe in capital gains taxes by selling less often.
- Reduces emotional trading: Trying to make rational decisions during market swings can be very difficult, which leads to emotional mistakes such as buying high or selling low. Passive investing minimizes how many decisions you have to make, which can reduce mistakes.
Cons of passive investing
- No chance for above average returns: Since passive investing tracks a market benchmark, your return is just going to be the market average. You won’t benefit from large, short-term trades.
- Lack of investment customization: Passive investing doesn’t give you as much flexibility to decide which investments go in your portfolio. You buy a fund that tracks a market benchmark, which includes both the good and bad investments in that benchmark.
- Exposed to market downturns: If you commit to a long-term, buy and hold strategy, it means you hold onto to your investments even during market downturns. There’s not the same flexibility to cash out and avoid losses, so you have to have the stomach to roll with the more difficult times.
- Less fun: Passive investing can be a little boring. The market benchmark does all the work for you and you aren’t as involved. That said, boring investing may be the best kind for many people — particularly those who are not financial experts.
Differences between active investing and passive investing
One major difference between active vs. passive investing is that active investing has a much wider range of potential returns. If you make good investment picks, you could potentially see a much higher immediate return than with passive investing. On the other hand, if your picks turn out wrong, you could lose a lot more money. With passive investing, you earn the market average based on the benchmarks you pick. There’s less upside but potentially less risk, making it a good choice for novice investors.
The active investing approach is also more expensive, due to the higher number of trades and capital gains, as well as fund fees. Passive investing allows you to minimize these taxes and fees. Finally, active investing takes more research and maintenance, as you keep an eye on market news. With passive investing, you don’t have to put in this work, as you can basically just set your portfolio for the long-term and let it run itself.
|Active vs. Passive Investing|
|Active Investing||Passive Investing|
|Best for...||More experienced, hands-on investors who want to be very involved with managing their portfolios||Less experienced investors, as well as those who don’t want to be highly involved with managing their portfolios (a set it and forget it attitude)|
|Investing approach||Frequent buying and selling investments in the short-term in an attempt earn high profits||A long-term, buy-and-hold approach that looks to earn the market average while minimizing taxes and fees|
|Fees||Higher, especially if you make frequent trades||Low|
|Average rate of return||Depends on your investment picks — can be above or below the market average, depending on your performance||The market benchmark average|
|Tax efficiency||Less efficient, especially if you make investments that last less than a year and owe short-term capital gains||More efficient due to a buy-and-hold strategy|
Should you choose active investing or passive investing?
For most nonprofessional investors, passive investing is the safer choice. The fees are lower, it’s easier and there’s typically less risk, as you consistently earn the average market return. If you’re an experienced investor and passionate about following market news, active investing could be worth considering.
Active investing may be more appealing if you have some specialized knowledge that gives you an investing edge. For example, you may be a scientist or doctor who understands the research behind pharmaceutical stocks. While active investing does have higher fees and greater potential risk, if your picks work out, you could potentially earn a higher return.
Your portfolio could also be a combination of both approaches. For example, you might invest your long-term retirement savings using a passive approach while keeping some funds in a brokerage account for active trading. That way, you give yourself the chance for some short-term profits. If your trades don’t work out, your passive investments could still reach your long-term goals.