Active versus passive investing
Whenever there’s a discussion about active or passive investing, it can pretty quickly turn into a heated debate because investors and wealth managers tend to strongly favor one strategy over the other.
UNDERSTANDING THE
DIFFERENCE
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 like the S&P 500 or Dow Jones. 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.
Active investing, as its name implies, takes a hands-on approach and requires that someone act in the role of 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’s investing the portfolio will know exactly the right time to buy or sell. Successful active investment management requires being right more often than wrong.
WHICH STRATEGY MAKES
YOU MORE
So which of these strategies makes investors more money? You’d think a professional money manager’s capabilities would trump a basic index fund. But they don’t. If we look at superficial performance results, passive investing works best for most investors. Study after study (over decades) shows disappointing results for the active managers. In fact, only a small percentage of actively managed mutual funds ever do better than passive index funds. But all this evidence to show passive beats active investing may be oversimplifying something much more complex because active and passive strategies are just two sides of the same coin. Both exist for a reason and many pros blend these strategies.
A great example is the hedge fund industry. Hedge funds managers are known for their intense sensitivity to the slightest changes in asset prices. Typically hedge funds avoid mainstream investments, yet these same hedge fund managers actually invested about $50 billion in index funds last year according to research firm Symmetric. Ten years ago, hedge funds only held $12 billion in passive funds. Clearly, there are good reasons why even the most aggressive active asset managers opt to use passive investments.