If you listen to analysts, brokers, or traders, you'll hear thousands of theories and philosophies on proper methods of investment. The two that really encapsulate most of it are active investing, and passive investing.
What Is Active Investing?
In essence, active investing is a hands-on approach. You invest in securities and watch them. You monitor them after buying them, and actively pursue actions that will take advantage of market conditions. An active investor very much believes that they can outperform the market by capitalizing on price movements, events, and conditions. A prime example might be investing in Gilead Sciences (GILD) - Get Gilead Sciences, Inc. (GILD) Report two months ahead of earnings on a dip, because you believe that a new pharmaceutical drug will cause bigger sales growth. Once the earnings are released, you sell the bump.
Another example might be investing in an actively managed fund, where the portfolio managers are actively choosing stocks, monitoring events, and making moves as opposed to simply buying an index fund that will largely follow the market. Many mutual funds operate in this fashion, and some exchange traded funds, to a lesser extent.
What Is Passive Investing?
Passive investing is more of what you might imagine Warren Buffet doing. Passive investment involves researching a stock, fund or ETF and then investing in its long term potential. You essentially "buy and hold." A passive investment doesn't worry about capitalizing on the short term or a particular event, and rather holds faith in the long term potential of an investment over a greater period of time. A passive investment strategy operates under the assumption that the efficiency of the market over the long term can and will yield the best results.
Active Investing vs. Passive Investing: What's the Difference?
The differences here are pretty clear cut. Active investing involves actively paying attention to your investments. If something happens that either creates incentives to add more shares or sell shares, you will do it. Active investment has no problem with short term gains. That's not necessarily to say that an active investor can't take a long position, but the strategy usually would cause someone to move their positions around more often than a passive investment.
A passive investor is not going to check their positions daily. If they buy 1,000 shares of Ford (F) - Get Ford Motor Company Report , the investor will sit on that big dividend and let the position develop over time with the market. If an active investment strategy involves buying 1,000 shares in Ford, active management might include the trimming or increasing of positions on events like "strong July truck sales" or things of that nature.
Pros and Cons of Active Investing and Passive Investing
Active investment definitely creates the opportunity for higher returns. By reacting to events and developments, one can take advantage of situations in order to increase returns and/or avert broader market pullbacks. This is why active asset managers within areas like mutual funds and hedge funds have been able to outperform the market at different points in time. However, for every active investor that beats the market, there are probably 10 that underperform.
Success is not guaranteed, and it's not an easy game. If it were, there would be a great many more billionaire investors. If your instincts are wrong on a short term position, you can lose a great deal of money quickly. If you sell too early because of a sudden price jump, you might miss out on the 30% expansion that occurs over the next 12 months. On a fund or portfolio level, the lack of ties with indexing creates the chance for you to both "beat the market", and "underperform" it.
Passive investment limits your potential for big returns. By buying and holding, you are operating at the pace of the marketplace; whether that is a single security or a fund. Most people invest in funds rather than individual stocks or bonds. These funds, such as ETFs and index funds, are usually pegged to an index that tracks a sector or industry. The costs and structures vary a bit, but that's the general idea.
When you buy these passive funds, you know what the holdings are, and are in for the ride with that grouping as it trades within the market. That said, because the funds are pegged to indexes within the market, it substantially decreases the risks of underperforming benchmarks. It is very much by chance if a passive strategy fund beats the marketplace by much.
You might make the counter that "Buffett does it." That's true, but most of his big gains were made by purchasing entire or massive chunks of companies, at negotiated preferred shares, with different dividends. He still purchases actual companies, rather than indexes.
Costs and Headaches
Active investment strategies definitely cost more in terms of transactions. On an individual level, the constant buying and selling will run up your fees for transactions. On a fund level, investing in actively managed funds will increase costs associated with the portfolio managers taking the time and effort to make the decisions, as well as the transactions. This creates the need for active strategies to produce higher overall returns than the market in order to offset the costs associated with it.
Passive investment removes a lot of that headache. Because you're basically investing in the market, you can buy index funds, and hold them. Even on a singular security level, a passive investor isn't going to trade Ford stock. They're going to hold and take the dividend and long-term price appreciation. On a larger level, it takes much of the cost out for fund managers and analysts as well. Since the index funds and ETFs are tracking indexes, you're not incurring the expenses of management.
Which Is the Better Investment Method?
The merits of either strategy are largely dependent on the economic cycle and market conditions. Leading into 2008, when things began to get very shaky, an active investment strategy certainly would have helped reduce risk in many areas.
The decision is also largely dependent on your personal knowledge. I absolutely prefer active investment management to passive. Granted, this is definitely going against the herd these days, but I simply find that I get better results when I am active in my positions. Being younger, I work with smaller amounts of capital. To that end, I seek out mistakes in the market where I can capitalize. Thus far I'm beating the market in 2019. Last year, I lost that game. So it really comes down to your considerations on risk, and ability to outperform.
You most certainly need a lot of time, research, and background in order to do this sort of thing properly. Therefore, the average person that is simply looking to grow their retirement is most likely going to opt for a passive investment strategy. If you don't have time to look at your portfolio daily, read up on all the events and economic conditions surrounding your investments, and then do the due diligence required to make the right decisions in terms of buying and selling, then active investment is simply too much to handle. Forgoing individual equities, even owning an actively managed fund requires knowledge and time. You have to research your portfolio managers. You have to research their holdings and past track record if you want to ensure you're not making a mistake.
Because of the extra work and risk, passive investment strategies are probably the best way to go for the average individual. You're helping ensure you don't experience downside below-market levels, while keeping your costs low. Not all active managers beat the market, and the average investor simply doesn't need that headache. That doesn't necessarily make passive investment better, as you are certainly lowering your return potential. It simply means you're decreasing risk.
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