There is a great debate over which is better within the investing world. One of the big questions is if active or passive investing is more effective.
Those who are in favor of active investing hold to the ability of astute fund managers to beat the managers and add “alpha.” Alpha is the amount of outperformance attributable to a manager’s skill.
On the opposing argument’s side, passive investing advocates cite the long-term inability of most active managers to beat the market. They also call attention to the high fees charged for sub-par performance and tax inefficiencies.
Not sure what side you lean toward in the debate of active vs passive investing? Here are some things to consider.
Active Investing – What Is It?
Active investing is the highly involved investment strategy in which the investor actively buys and sells, performing continuous monitoring to exploit profitable market conditions.
Most active investors are looking for movements in their stocks many times a day. Typically, active investors are looking for short term gains as opposed to long term ones.
The desire to beat the market is a powerful addictive force, but only a time machine can predict the future. Active investors spend a considerable amount of time and money searching for superior returns through active management.
What Is Passive Investing?
Passive investment, also known as a buy-and-hold strategy, is practicing an investment strategy which involves buying securities with the intention of owning them for many years.
Passive investing aims to maximize returns by keeping the amount of buying and selling to a minimum over the long term. The idea behind passive investment is to avoid the fees and drag on performance that can potentially occur from frequent trading.
The passive investor is not motivated to make quick gains or to get rich with one great bet. Rather, the passive investor’s goal is to build slow, steady wealth over time.
Generally speaking, passive investors look to construct well-diversified portfolios through asset allocation so they can replicate market performance. The process of constructing a well-diversified portfolio can require extensive research.
Pros and Cons – Active vs Passive Investing
There are some pros and cons to both active and passive investing, but I will personally argue that passive investing is the way to go since active investing can cost an additional 0.6 to 1.5% in fees. This means you would need to not only beat the market, but also beat it more than the additional fees.
Nevertheless, I want my readers to have all the information to make informed decisions for themselves.
Active Investing
Proponents of Active Investing tout the following as advantages
- Flexibility – you are not required to hold specific stocks or bonds
- Hedging – you can use short sales, put options, and other strategies to mitigate losses
- Risk management – you can get out of specific holdings or market sectors that exhibit large risk
- Tax management – Strategies are tailored to the individual investor like tax-loss harvesting
One large disadvantage to active investing is that it is costlier – there are higher fees and operating expenses.
Detractors feel that higher fees are a significant impediment to consistently outperforming the market over the long term.
Active managers, in general, will have a more concentrated portfolio with fewer securities. This is done in an attempt to beat the market. The issue with this approach is that when active managers are wrong, they may significantly under-perform against the market.
Passive Investing
Passive investors tout the following – as well as others – as advantages
- Very low fees – no need to analyze securities
- Good transparency – investors can see what stocks or bonds an indexed investment contains
- Tax efficiency – the buy-and-hold style doesn’t incur a large annual capital gains tax or even being taxed at income rate if sold before a year’s time.
Detractors of passive investment say that it too closely matches the performance of the index.
The passive investment manager tries to duplicate the chosen index, tracking it as efficiently as possible. Tracking the chosen index closely results in lower operating costs. The manager then passes this lower cost on to the investor in the form of lower fees.
Another argument against passively managed investment is that it will never outperform the underlying index it is tracking. Investors must be ok with the performance of the chosen index. However, on the contrary it has been proven that active investors only beat the market 45% of the time.
Note that this doesn’t mean they beat it to the point where their fees are worth it. Furthermore, the track record report of any individual fund manager could be due to chance and change in the future so analyzing their returns to foresee future success is a loser’s game.
A final downside is that managers are not able to act if they believe the market will decline or that individual assets should be sold
Active vs Passive Investing
You can see that there are pros and cons to both active and passive investing.
Wall Street of course advocates active investing – they have a vested interest and employ a talent marketing and sales army to promote it.
Yet despite all the time and money spent trying to beat the markets, the overall net result falls far below expectations.
Though it takes some research up front, passive investment may be a better strategy for long term wealth building – one that is in the best interest of investors despite the impulse for beating the market and short term gains. Even Warren Buffett’s has agreed that index investing is superior than investing in his own company.
Passive investment is very stable. It helps balance portfolios and avoid panicked selling and buying based on short term profit desire. Stay tuned for a more detailed analysis on the subject where I display the difference on returns and the drag high fess can have on a portfolio.
What are your thoughts on active investing? Did this article help define anything or change your opinion?
