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.