If you're new to investing, welcome! In this article, we will be discussing the differences between active and passive investing.
You may have noticed that we have a beginner and intermediate guide to investing on our blog, which will run you through how to invest, analyze stocks and manage your portfolio.
Do check them out first if you haven't already, as these will give you a better idea of what investing entails, which is a good precursor before reading this article.
If you've read through these two guides, you'll know that investing is not something that's easy to do. Instead, it actually requires quite a bit of effort on your part.
Researching products, reading through reports, looking at discussions, managing and rebalancing your portfolio... all of these can add up over time as you purchase more and more financial instruments.
For some, they would much rather focus on their main job and leave investing to the sidelines. Many don't have enough time to spare or do not wish to put in the effort into managing their own portfolio.
Luckily, there are various strategies in investing, and some require less effort than others to do. In this article, we'll examine the differences between passive and active investing, and why you would chose either one for your investment strategy.
What is active investing?
Active investing generally involves a more hands on approach, such as the ones we have been discussing throughout the course of the guides.
Generally, active investing is about managing your own portfolio, and picking out individual financial instruments to try and achieve as high a return as possible while managing your risk.
As such, active investing aims to beat the market. Naturally, this involves much more work on your part, including understanding market conditions, analyzing stocks and deciding when to buy and sell to try to maximize your profits.
Some examples of investment products that are considered as active investing include:
- Unit trusts
- Mutual funds
- Real Estate
- Your own equity selections
What is passive investing?
Conversely, passive investing is where investors don't try to beat the market. Instead, they are more content with following it. Usually, this means buying into things like ETFs, which track a market index. As the index rise, so do the ETFs, and vice versa.
With passive investing, you're generally aiming for more long term profits. Instead of worrying about when to sell, you generally try to buy and hold it for as long as possible to benefit from compounding growth.
This means much less work as compared to active investing since you're not trying to time nor beat the market. All you have to do is buy funds that track the market when you have extra capital and hold them.
As such, there's no need to research individual stocks or financial instruments - just buy the basket that holds all of them and wait.
Some examples of investment products considered to be under passive investing include:
- Exchange traded funds
Note that while robo-advisors usually automate your portfolio allocation for you using ETFs and index funds, some may choose to allocate portions into other things like commodities and bonds, which may seem reminiscent of active investing.
You can think of it where active investing is like picking what you think are the best berries in a basket full of berries, while passive investing is taking the whole basket itself, without thinking too much about the berries inside it (although you think that overall, the basket consists of mostly good berries).
Benefits of active investing
The goal of active investing is to naturally maximize the profits instead of merely following the market. However, this does not always occur even with active management.
After all, only a small percentage of actively managed funds manage to outperform the S&P500 index.
From this data, it may seem easy to conclude that passive investing is technically superior in every way - it's easy and provides better returns, right? Just throw your money into an index fund!
However, everything must be taken with a grain of salt.
Note that this is the S&P500, a blend of 500 of the world's largest and strongest companies. It is extremely hard to find financial instruments that outperform the growth of the world's best companies.
Additionally, the data was collected during 9 years of continuous market growth, one of the longest bull runs in history. With everything growing, it's difficult to find good, undervalued picks.
In truth, the main benefits of active investing exist under two conditions:
- The market conditions are uncertain.
- You are confident in certain companies but less so for the whole collection of them.
Let's examine each condition one by one. Firstly, if we're coming off a recession, it is almost a given that the entire economy will enter a period of recovery and good growth.
If the whole market is growing, it is almost risk free to buy into a passive index fund or ETF and simply reap the profits. This makes passive investing very attractive over active investing.
But what if we're at the height of a bull run? What if prices appear to be at all time highs across various markets? Would you still buy into these passively managed funds with confidence?
Perhaps not. Perhaps you might search around for any undervalued stocks with good prospects and invest in those instead. Or you might be fearful and minimize your risks by investing more into fixed income instruments like bonds.
To make an analogy, this is like having an entire basket full of fruits. When the fruits are all unripe and growing, it may make sense to simply buy the whole basket and watch them grow.
However, if all the fruits appear ripe, you might want to pick and choose a few unripe fruits with good growth out of all the fruits in the basket that have long term growth potential instead of buying the whole basket.
In such uncertain environments, active investing might be more assuring, since you have greater flexibility of choice.
The strength of active investing is that it allows for specific diversification to your portfolio. When rebalancing, we generally want to achieve a certain goal, such as lowering our risk, or increasing our exposure to certain industries or markets.
If we invest passively, we are restricted to buying the whole collection, which may not achieve our goals properly. Active investing allows us to be specific with what we buy, providing us finer control over our portfolio.
Secondly, active investing shines when you have your eye on a certain financial instrument that you have confidence in.
Again, let us use the S&P500 as a prime example. Here, we compare Apple's (part of the S&P500) returns against the returns of the entire S&P500 itself.
As we can see, Apple averages a 14.88% higher return than the S&P500 index. Overall, if you had "actively invested", you might be able to pick out the better fruits within the basket of fruits, increasing your returns past the market.
If you have long term confidence in a particular financial instrument within the basket, then it may be better to buy some of that instead of the whole basket. This allows you to reap the profits of better companies.
While indexes like the S&P500 can be unnaturally good for passive investors, other diversified indexes such as those that track emerging markets may not perform as well over time.
Instead, picking and choosing the best instruments out of the whole collection may serve to provide better returns.
Of course, this main perk of active investing is also its main drawback. After all, it is not easy to find and pick out these golden eggs. It also results in less diversification.
As covered in our intermediate guide to investing, it can involve a lot of market research, company analysis and report reading, which could take up a lot of time and effort.
Active investing also comes with greater risks. If you choose correctly, great! You'll get returns above the market and enjoy good profits. But if you choose wrongly, then you are in for a world of pain.
With active investing, you generally incur greater fees as well, due to having to pay higher expense ratios for fund managers to trade with their expertise. Similarly, if you're choosing your own stuff, you may pay more fees on each trade rather than simply buying the whole collection.
Benefits of passive investing
Now, let us take a look at passive investing instead. Passive investing mainly exists to avoid the risks described above.
Effectively, all you have to do is determine your initial portfolio allocation and stick with it. Here, we just pick a few baskets that we want to buy from and just put money into it when we have the capital.
By focusing on a long term buy and hold strategy, we are able to free up a lot of time and effort since we do not have to consider the individual instruments, but merely the basket as a whole.
An analogy would be that instead of searching for a needle in a haystack, or even multiple needles, we just take the whole haystack.
The best part is that the returns aren't too shabby either. In fact, since passive investing usually buys into an index fund or similar instruments, the returns we get follow the market.
If the market grows (which it usually does), then we get pretty good returns with effectively zero thought. If the market crashes, sure we'll take a hit, but markets usually recover after some time.
We could just as effectively view the market crash as a discount sale, where we can buy more instruments at a cheaper price, and reap the profits as the market recovers.
As such, passive investing has four main benefits:
- Less time and effort since you don't have to research.
- You get pretty good profits that resemble the market, which usually grows.
- Greater diversification due to buying the whole basket.
- Less fees involved due to passive management (just track the market).
Of course, this comes with two trade offs. Firstly, since we are buying a whole basket of securities at a time, it is difficult for us to rebalance our portfolio to fit our risks.
For example, let's say a collection of financial instruments isn't performing well overall, but some of them are.
With passive investing, to avoid having to research multiple instruments, you just take the whole basket with its flaws, which may hurt your returns.
That said, passive investing is generally of a lower risk since you are more diversified than active investing. Still, we may want to incur more risk sometimes to achieve higher returns.
Thus, the second drawback is that you will never achieve returns higher than that of the market, which may or may not be what you want.
Sometimes, we want to take more risks to get more reward, but passive investing negates that choice.
In summary, the biggest differences between active and passive investing are as follows:
|Active investing||Passive investing|
|Tries to beat the market||Follows the market|
|Requires active management||Passive management (to match the market)|
|Usually has more fees||Usually has less fees|
|Usually requires more effort & time||Usually requires less effort & time|
|Less diversification||Greater diversification with lower capital|
|High risk high reward||Lower risk and decent reward|
|More specific and flexible||All or nothing rebalancing|
Should I choose active or passive investing?
For most individual investors, passive investing is highly recommended. This is because most people do not have enough time to properly research various financial instruments.
If you work a job, and you still have to research on all these investing options, your time would be solely spent on money. Of course, if this is your passion or hobby, then great! Otherwise, your time would be better spent on yourself instead.
After all, money is just a means to an end, as we like to say. You should make money work for you, and not the other way around.
Of course, the main reason why individual investors should pick passive investing is because we may not have enough expertise in the market to do otherwise.
Now, I'm not saying that individual investors can't pick out good investment products - many do - but that the majority of individual investors simply don't put in the required time and effort to do the needed research.
Do you read through a company's financial statements, read their news, and follow all their press releases? Do you know what the company target market is, the brands under it, and the product that it sells?
Perhaps you are simply thinking of buying it because your friend or advisor recommend it to you. However, many active managers don't even outperform the market. Can you trust them?
As individual investors, active investing can be very difficult because we wouldn't know most of the time if we want to take on that risk.
For example, Google's (Alphabet) price to earnings ratio was 40 in 2008. Would you have dared to buy it with such a high P/E ratio?
If you did, then Google's stock price has risen from $230 per share in 2008 to $1400 in 2020. That's a 6x profit! But would you have dared to buy it as such a seemingly overvalued price back then?
Would you be able to understand Google's company fundamentals and make the decision that it would grow well into the future based on its profit model? Perhaps, perhaps not.
As individual investors, most of us are limited by the information and knowledge that we have, and even then, we are limited by our ability to rationalize our decisions and take on that risk.
Therefore, it can be easier for us to take on passive investing instead. By buying into the whole collection of the market, we take most of the thinking and research out of the equation, allowing us to focus on our other pursuits.
It simply is a safer option, and the returns aren't necessarily worse either.
However, this doesn't mean that there is no place for active investing for an individual investor.
As we examined in our intermediate guide to investing, portfolio rebalancing is crucial in order to maximize our profits while ensuring we remain within our risks.
While passive investing is optimal for the individual investor to grow their wealth with lowered risks and minimal time and effort, active investing becomes important for investors wishing for higher returns or to navigate uncertain territory.
For example, suppose you want to introduce more liquidity into your portfolio, such that it generates more cash flow for you without having to sell your assets.
A passive investor may choose to buy into a REIT or an ETF that pays out dividends and just be done with it.
However, what if said REITs or ETFs are at all time highs and seem unstable? An active investor might look through the components and pick out certain specific products that appear more attractive and have stable dividend payouts.
In a recession, one or more companies may cut their dividends. This lowers the value of the entire basket as a whole. However, if you had bought the safer options within the basket that had a sustainable payout ratio, their dividends might survive through the recession, giving you a stable cash flow.
In some cases, active investing may be preferable, such as in the rare case you find an undervalued asset or have a specific situation you wish to have finer control over.
For most investors, passive investing is recommended - it's simply easier, and you will still get decent returns if you buy and hold over the long term. If you have no time to learn and research, this is the way to go.
For investors who have more experience and would like to take on more risks for better returns, a combination of passive and active investing might be the way to go.
In times of growth, passive investing shows its strengths, allowing us to take advantage of the growth of the overall market without worrying too much about its constituents.
However, if we spot a good gem within the basket, and you're willing to bear that risk, then it would make sense to actively invest and scoop it up for a chance at better profits.
In times of uncertainty, active investing can also be a good way to fine tune and control your portfolio's direction to better suit your needs and liabilities, as opposed to passive investing where you are at the mercy of the market and your portfolio doesn't quite work for your goals.
Therefore, we would suggest passive investing for new investors, and those with lower capital. It has less risk, and gets your feet wet in investing at the same time. Passive investing can also give greater profits than active investing!
As you get more experienced and have more capital to spare however, take a look at active investing. It isn't always the best, and is more risky, but it's a good tool to have in order to make your portfolio fit your financial goals.
A combination of the two methods may actually serve you better for your investing needs - so always remain open to the possibility!
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