Passive investing vs. Active investing: which is right for you?

What if you could invest in the markets without too much effort? Well, that can be done with passive investing. However, is this strategy the right fit for you? That is to be discovered!

What is passive investing?

Passive investing is an investment technique that aims to improve investment returns by reducing the amount of money spent on buying and selling financial products. The essence of passive investing is a buy-and-hold strategy, a long-term approach in which investors don't trade in and out of individual stocks very often.

The goal is to match, not beat, the performance of the financial indexes.

One of the most common approaches to passive investing is index investing, a popular passive investment technique in which investors buy a representative benchmark, such as the S&P 500 index, and hold it for a long period of time. This can easily be done using exchange-traded funds (ETFs). The indexes’ main advantage is that they automatically adjust their holdings. Thus, investors do not have to re-balance their portfolios themselves.

Key advantages of passive investing

  • Simplicity: Passive investing tries to duplicate the market’s performance by building well-diversified portfolios of single stocks, which would need substantial research if done individually.
  • Lower fees: Because no portfolio managers are picking stocks, management fees are significantly less costly, and operating expenses are lower.
  • Tax-efficient: The buy-and-hold strategy results in lower capital gains taxes because long-term investments are taxed at a lower rate and tax doesn’t apply to unrealized profits.
  • Diversification: Passive investing via indexing is a simple way to achieve diversification.

Key disadvantages of passive investing:

  • Market risk: Since index funds track the market, passive investing is subject to the volatility as the market, which during bear markets can be hard to stomach.
  • Lack of flexibility: Returns do not outperform nor beat the market as the index funds are designed to closely track the benchmark.
  • Stuck with the stocks: Regardless of how well or bad the stocks in the index they track do, passive managers are stuck with them.

What is active investing?

Any approach that involves monitoring the prices of your positions to locate buying and selling opportunities is known as an active investing strategy. Acquisitions are made based on research or analysis, and the portfolio's purpose is usually to outperform a benchmark.

A benchmark can be an index or a mix of indices that offer some measure of how the overall stock market or segment of the market has performed. The amount the investor outperforms their benchmark is referred to as an alpha return. Active investors are looking to achieve alpha when they invest. To do so, investors use a variety of investing strategies such as value investing or market timing, a strategy that aims to anticipate the future movement of a stock, which allows them to trade accordingly.

Key advantages of active investing:

  • Hedging: Active managers can also use tactics like short-selling or put options to hedge their bets, and they might abandon certain companies or sectors when the risks become too great.
  • Flexibility: Active managers can choose every element of their portfolio.
  • Short-term opportunities: Traders can take advantage of the momentum and benefit from short-term highs or lows.

Key disadvantages of active investing:

  • Cost: actively managed funds are pricey. Due to all that buying and selling, they involve lots of transaction costs and fees.
  • Active risk: although investors try to predict stock’s movement, they can never be 100% sure about the future which can be very risky. In recent years, most active managers have underperformed their benchmark.

Passive vs Active Investing

Passive strategies, on the other hand, don’t focus on short-term fluctuations in a stock’s price. Passive investing also involves little to no research or analysis of individual companies. Instead, investors focus on spreading their money across many stocks or diversifying to gain exposure to the stock market. In this sense, passive investing doesn’t aim to beat the benchmark but instead to mimic it.

One focuses on analysis and valuations trying to achieve alpha and the other on diversification and long-term exposure. But why don’t passive investors also try to earn alpha? Well, the reason has to do with how passive investors view the market and individual investors’ knowledge. Passive investors largely believe in the efficient market hypothesis.

What is the efficient market hypothesis?

Efficient Market Hypothesis (or EMH) is a theory that was developed by Eugene Fama in the 1960s that states that at any given time a stock’s price will reflect all available information and trade at its fair value. All this means is that investors cannot identify stocks that are too expensive or too cheap.

EMH states that everything will trade at its intrinsic value, thus making it impossible to consistently generate alpha. After all, with so many traders participating in the market researching companies and looking for new information, the resulting buys and sells on aggregate should bring the stock price close to its actual worth.

Active investors on the other hand don’t believe that markets are completely efficient. Instead, they believe a stock’s price can often deviate and they try to extract an alpha out of these fluctuations.  

The takeaway: Should I try passive investing?

Passive investing has become more and more popular over the years. It's a simple, low-cost investment option, which is suitable for amateur investors because it eliminates the need to spend a lot of time studying stocks and watching the market.

The key principle of passive investing is that individuals who wait for the market to rise would profit financially in the long run. And that trading with the bare minimum gives the best results. The strategy is thus better suited to investors who prefer to be hands-off and have long-term goals. An active strategy is the way to go for those who want to try to beat the market and are willing to pay higher fees to do so.

Passive investment, on the surface, appears to be the greatest option for most investors as studies show disappointing results for the active managers over the years. Indeed, the last 10 years (2021 not included) passive was on a winning streak over actively managed stock funds.