Passive vs Active Investment
Active Investing
Active investing, as its name implies, takes a hands-on approach and requires that someone act in the role of a portfolio ,manager. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond, or any asset. A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors, then gaze into their crystal balls to try to determine where and when that price will change.
Active investing requires confidence that whoever is investing the portfolio will know exactly the right time to buy or sell. Successful active investment management requires being right more often than wrong.
Passive Investing
If you’re a passive investor, you invest for the long haul. Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality. That means resisting the temptation to react or anticipate the stock market’s every next move.
The prime example of a passive approach is to buy an index fund that follows one of the major indices. Whenever these indices switch up their constituents, the index funds that follow them automatically switch up their holdings by selling the stock that’s leaving and buying the stock that’s becoming part of the index. This is why it’s such a big deal when a company becomes big enough to be included in one of the major indices: It guarantees that the stock will become a core holding in thousands of major funds.
When you own tiny pieces of thousands of stocks, you earn your returns simply by participating in the upward trajectory of corporate profits over time via the overall stock market. Successful passive investors keep their eye on the prize and ignore short-term setbacks—even sharp downturns.
Key differences between active and passive investment strategies
Active and passive investing have one big difference: cost.
Active investment funds come with a much higher fee, due to the team of analysts needed to actively buy and sell stocks. Ultimately, most clients incur trading fees when they actively trade.
Passive investment funds are considered very low cost. Since there is no team of analysts looking for stock picks or overhead needed to employ them, there is only a small fee associated with buying these funds.
Put simply, passive funds just follow a certain index, allowing investors to piggyback on a secure trajectory. The ease of this product allows for reduced fees.
Proponents of passive investing, such as the famous Warren Buffet, are likely to denounce active investing because of these additional charges. To passive investors, you are losing possible returns by paying for the work done by the portfolio managers at actively managed funds.
As recently as 2016, Warren Buffet said this about passive investing: “When trillions of dollars are managed by Wall Streeter’s charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”