Active Vs. Passive Investing

Which Trading Strategy Is Right for You?

Active Vs. Passive Investing
September 23, 2015

Congratulations! You are about to dive into the stock market and build your future wealth. However, you are confused about the best strategy. You have heard people touting both active and passive investing, but are not sure which one is right for you. In general, active investing is a more aggressive strategy while passive investing is a conservative strategy (as the names would imply).

Active investing assumes that you are aggressively trying to find the best stocks with the greatest upside at the lowest price — in other words, bargains. By timing the market and analyzing trends, you try to buy low and sell high with all the stocks or bonds in your portfolio.

Passive investing involves picking a representative of stocks or funds to meet a goal, and generally leaving them alone. Passive investors assume that the overall market tends to counter losses with gains, and these funds are adjusted far less often than active funds — if they are adjusted at all. Index funds that are managed to track a particular index (such as the S&P 500) are gaining in popularity because of their lower fees.

In active investing, you want to beat the market. In passive investing, you want to own the market.

Costs are inherently higher with active investing for two reasons: the strategy requires more trades and therefore more fees with each trade, and you have to pay for a fund manager with the insight to know when to make those fees. By definition, an active fund has to outperform a passive fund to produce the same return.

Do they perform up to this standard? Not lately, they don't.

According to S&P, 86% of managers of large-cap active funds fell short of their benchmarks in 2014. Over the past five years, the underperformance rate was 89% and 82% over a ten-year period. Note that this does not necessarily mean that passive funds outperformed them, just that goals were not met.

How about a direct comparison? Barron's notes that from 2004-2013, 45% of active managers managed to beat indexes, with the majority doing so by less than 1%. The majority of underperformers stayed within 1% of the index also. In essence, you are paying more for similar performance.

In that case, why does anybody follow active investing? It is still the most popular method, with close to a 3:1 ratio of investors in active funds. One reason is that passive investing can suffer from the very inflexibility that makes it successful most of the time.

For example, the recent plunge in oil prices is throttling funds in that particular sector. Active managers dealt with that risk long ago; passive funds are absorbing the losses for now expecting them to reverse. They will, eventually... but how long will it take? Longer-term investing generally favors the passive; short-term can favor the active.

Active vs. passive is not cut and dried — within each philosophy there is a range of actions. Some active funds are more risk averse since the 2008 crisis (based on the results compared to the index, we would say most of them), and some passive funds may rebalance portfolios often enough that they border on aggressive. You have to look over individual funds and fund managers to get a feel for how that fund operates and whether it fits your needs.

In the end, you should choose either an active or a passive strategy depending on your tolerance for risk, your time horizon, and your interest and acumen in financial matters. Over the long haul, the passive approach seems to be the best choice for most investors. However, you can do very well with active investing if you make the right choice in funds (or direct stock investments, if you are a DIY investor), monitor the funds carefully, and are willing to take the time to analyze trends and take the necessary risks.


Photo ©iStock.com/hocus-focus

  Conversation   |   29 Comments

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Daniel Dohlstrom | 09.23.15 @ 16:02
Knowing which is right for you is very important, understand what risk you are able to endure, and do not be afraid to change your style if your circumstances change
Steffanie | 09.23.15 @ 16:03
I would be the passive one. Not much of a risk taker here.
Elaine | 09.23.15 @ 16:03
I'm not a risk takers the all, so I normally just completely avoid the stock market altogether.
Bobbie | 09.23.15 @ 16:06
We are pretty passive in our household. Too close to retirement to take any big risks.
Erin | 09.23.15 @ 16:08
I would think the younger you are, the more benefit an active strategy would have for you so you have time to recoup any potential losses.
Nancy | 09.23.15 @ 16:10
I don't take a lot of risks. I definitely would not be an active investor.
Britt | 09.23.15 @ 16:12
I prefer active myself. Lots of good info
Kyle | 09.23.15 @ 16:13
Good info. Great article.
Sara | 09.23.15 @ 16:13
Never thought about it like this. However, since we are fairly young we have been risk takers.... Not always to my liking though.
Kailie | 09.23.15 @ 16:15
I didn't eve know that there was a difference in types.
Beverly | 09.23.15 @ 16:16
I would love to be the active investor, but lack of knowledge and lack of courage keep me in the passive investor category
Morgan | 09.23.15 @ 16:17
Great article. I would think passives are much more higher risk takers.
Angie Taylor, Insurance Agent in Montevallo, AL | 09.23.15 @ 16:18
Sounds like i am more of a passive type
Alec | 09.23.15 @ 16:20
I'd have to say I'd be more interested in passive investing. I wouldn't want to risk constant buying and reselling. It would stress me out!
Chelsey | 09.23.15 @ 16:22
I would most likely be considered passive. I don't like taking risks. I like a sure thing.
Kamie | 09.23.15 @ 16:26
I am a passive person, I have what I want in the stocks, and I do not pay much attention to it.
Ron | 09.23.15 @ 16:34
I am a mix of the two. I keep a bit of my investments on a trigger and buy and sell with some regularity, but I have my others stocks known for sitting and casually growing each year.
Angie | 09.23.15 @ 16:36
Looks like from the responses that we are mostly non-risk takers. I suppose the market does better having more of the non-aggressive investors?
Kaila | 09.23.15 @ 16:38
We are pretty passive, not huge risk takers
Shannon | 09.23.15 @ 16:41
I'm not risking it now, younger generations should try though
Vaughn | 09.23.15 @ 16:46
I really want to learn more about investing in the stock market but am scared of taking the risk.
Christina | 09.23.15 @ 16:52
I would think I'm pretty passive. Don't like taking risk.
George Middleton | 09.23.15 @ 16:57
Interesting.. Never thought of it like this.
Sarah | 09.23.15 @ 16:57
Good breakdown on the two types.
Stokes | 09.23.15 @ 17:04
I'm a passive invester. We work too hard for our income to have it flittered away with risky investments.
Heather | 09.23.15 @ 17:11
When it comes to my money I am very passive. I work to hard for my money to take risks.
Jackie | 09.23.15 @ 17:20
I'm the passive investor. In it for the long term.
Christina | 09.23.15 @ 17:25
My style has been pretty passive - more so as I've gotten older and can less afford to take risks
Carla Truett | 09.23.15 @ 17:25
I'm definitely not a risk taker with money which would I'm sure hold me back a lot in the stock market.
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