Active vs. Passive Investment Strategies: Understanding the Differences

There is no one-size-fits-all approach to investing, and both active and passive strategies can help investors increase their wealth. There are a number of key differences between these two types of strategies, which can influence both your long-term financial objectives and the journey towards attaining them.

What is an Active Investment Strategy?

An active investment strategy is based on the act of buying and selling assets at a high frequency. Those pursuing an active approach are generally looking to capitalize on rapid changes in the market, making numerous decisions based on fresh information and datasets.

In contrast to a more passive approach, an active strategy is one that seeks to perform better than the overall results of the market. Active investing is usually the purview of professional money managers, as those who undertake this approach must believe that they have the ability to navigate the markets and outperform them. Management fees constitute an extra cost for those following an active investing strategy.

An active investment strategy often goes hand-in-hand with an aggressive approach, which seeks to place monies in more volatile assets and asset classes. These tend to move both up and down more frequently, depending on changes in the market.

What is a Passive Investment Strategy?

A passive investment strategy is one that aims to keep pace with the markets, generally through holdings of investment vehicles such as index funds, mutual funds, or ETFs. These types of investments are comprised of numerous holdings and assets, which can be designed to mirror the markets themselves.

For instance, one popularly-cited index fund is the Standard & Poor’s 500 (commonly referred to as the S&P 500). The S&P 500 (SPX) is made up of some of the largest companies listed on stock markets in the United States. Though it can fluctuate year-to-year depending on the state of the economy, over the past 60 years it has consistently delivered close to 10% returns.

Investing independently in blue-chip or dividend aristocrats can also be part of a passive investment portfolio, as these established companies are generally stable and secure. While you might miss out on the massive growth potential of a tech unicorn, you are decreasing the scope of risks you are taking with your money.

With passive investing, value is gained over time and not through the constant buying and selling of assets. For this reason, a buy-and-hold strategy over the long haul is part and parcel of a passive approach. It follows that this lowers the fees that you will need to pay fund managers, as the amount of trading activity is decreased.

Active or Passive Investing: Which One is Better?

Like everything in life, the choices you make boil down to your personal goals and preferences.

For most individuals, a passive approach to investing is the most comfortable financial pathway. Especially for those who are placing their monies in the stock market, a passive approach will allow them to make investments in relatively safer companies that they plan on holding for the long-term. This does not mean that they should remain unaware of their portfolio’s performance, or the need to make changes and adjustments as required. The frequency and quantity of these trades will simply be less significant.

Historically, passive approaches have tended to perform better than active accounts in most cases. Beating the market, almost by definition, requires making decisions that go against conventional wisdom. It is much easier to place monies in investments that have performed well in the past, and seem likely to continue generating value into the future.

There is also an increased tax liability which can crop up with an active approach. Profits from the selling of stock are taxed, though the length of time that the investments are held impacts the level of taxation. Investments that were held a year or more will be taxed at the capital gains rate, whereas those that are held for less time will pay taxes at the ordinary income tax levels.

However, there are reasons to opt for an active approach. Passive investors–especially those who are invested in index funds or ETFs–lack the flexibility to quickly shift their portfolio to take advantage of developments in the market. Active investing provides investors with more freedom to always remain on the hunt for profit and value.

Active and Passive Investing: A Hybrid Approach

Active and passive investing each have their advantages, and there are plenty of finance professionals who encourage borrowing elements from both approaches.

For instance, an investor could place the vast bulk of their investments in larger funds, savings accounts, and dividend-paying stocks, while placing a smaller portion in an actively managed mutual fund that is focused on small cap companies and international markets.

If the investor has both the time and interest, they could also consider actively managing their own funds through regular trading in the stock market, cryptocurrencies, or ETFs.

The percentage of funds in each individuals portfolio can adapt through the years as their financial situation, goals, and even familiarity with the market changes. Therefore, it is always a good idea to review both your portfolio and your investment approach on a semi-regular basis to make sure that they fit with your short- and long-term objectives.

Conclusion: Defining Your Investment Goals

Active and passive investment approaches each have their respective merits. Deciding between the two generally boils down to your investment objectives, and whether you want to try and beat the market or keep pace with it.

For most novice investors looking to save for retirement, a passive approach is usually the best fit. The market has historically done well over time, and keeping your money consistently invested is one less thing on your daily to-do list. That being said, there are others who prefer to control their own financial destiny through actively searching for value-generating investments.

Active and passive investing approaches can each make sense, depending on your financial situation, preferences, and interest in following the market. Understanding the pros and cons of both approaches can help you determine which approach is best suited for you.

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