Active vs. Passive Investing

By
6 Minutes Read

Hands-on or hands-off – which strategy is best for you? 

As a new investor, one of the first decisions you need to make is whether you want to invest actively (for the short term) or passively (for the long term). If you’re not sure what the difference between active and passive investing is or what the benefits and drawbacks of each might be, don’t worry — we’ve laid out a comprehensive guide with a few examples so you can decide what’s best for you and your investing goals. 

 

 

What is active investing?

 

 

Active investing is a hands-on investment strategy that involves frequently buying and selling securities. This buying and selling can be handled by an individual investor like yourself or handed off to a portfolio manager if you don’t have the time, money, or desire to analyze the market all day, everyday.

The goal of active investing is to beat the market or outperform a benchmark (a standard used to measure an investment’s performance). This requires consistently monitoring the market to take advantage of short-term stock price fluctuations. As stock prices rise and fall throughout the day, active investors determine precise times to buy and sell securities to make the highest possible return.

For example, an active investor might plan to buy shares in a technology company the day before they release an innovative product and then sell those shares the next day once stock prices have increased.

The kind of analysis required to find promising opportunities is difficult, so active investing usually requires a portfolio manager and a team of analysts who look at a number of different factors within the market and then attempt to predict how investments will perform.

 

The costs of active investing

Here’s the thing – the costs associated with active investing (like management fees and trade commissions) can seriously add up. Your investment would have to exceed the benchmark enough to cover these expenses (with money left over) to make active investing worth your time. Unfortunately, you’ll have to pay management fees regardless of how successful your investment is.

 

What about risk?

Active investing allows for more flexibility. Portfolio managers can try to predict upcoming market conditions or react very quickly after they happen to reduce the negative impact on their client’s portfolio. They can also react very quickly to profitable market conditions. By responding in real time, they have a better shot at beating the market or outperforming a benchmark.

If they’re right, you’ll win big. But if they’re wrong, your portfolio will take a hit. That’s why risk is substantially higher in active investing. Even though the goal is to beat a benchmark, there’s no guarantee an active fund will achieve this.

It’s also easy to get caught up in trends when actively investing, especially if you’re doing it yourself, which only adds to your risk because of how difficult it can be to determine if you’re at the peak of the trend.

 

 

Active investment strategies

 

Mutual funds

Mutual funds pool money together from multiple investors and invest it in a collection of securities (like stocks or bonds) that make up the fund. They often require small initial investments and offer the benefit of diversification by investing in several different securities, which reduces risk by dividing your “eggs” between many “baskets.”

Most mutual funds are actively managed — a fund manager determines which securities to buy and sell for the fund with the goal of beating the market.

 

Actively managed exchange-traded funds (ETFs)

ETFs, or exchange-traded funds, bundle multiple assets together to trade as a single product on a financial market. ETFs typically track indexes, industry sectors, or specific types of investments and are usually a passive investing strategy — but not always.

Some ETFs are actively managed by a professional. These funds often track an index, just like passive ETFs, but allow a manager to make changes to the fund – like adding or removing securities. Therefore, actively-managed ETFs can respond to shifts in market conditions and attempt to maximize returns. BTW, an index is a hypothetical portfolio of investments that represents part of a financial market. You’ve probably heard of stock market indexes like the S&P 500, which tracks the performance of 500 companies to represent U.S. market trends. Our blog on index funds goes into much more detail on how this works!

 

Hedge funds

Similar to mutual funds, hedge funds pool money from (usually very wealthy) clients to invest in financial markets. The difference is hedge funds invest in a wider variety of financial products than mutual funds, and are typically high risk, high return.

Because of the high levels of risk, only investment professionals with a net worth of more than $1 million or who have earned an annual income of more than $200k for the past two years can invest using hedge funds. Hedge funds typically charge both a management fee to cover daily expenses and a performance fee calculated as a percentage of the profits, which is paid to the fund manager to incentivize greater returns.

Hedge funds are 100% actively managed (all hedge funds require a manager) and are not very accessible to individual investors.

 

Actively managing your own trading account

Of course, you don’t need to use a professional – or invest in a mutual or hedge fund – to take an active investing approach. You can watch the market to time short-term trades on your own. Just know, in order to see high returns you’ll have to commit a lot of time and effort to the process – this method probably isn’t ideal for a new investor. Also, frequently trading investments held in a Tax-Free Savings Account (TFSA) can actually result in fines – check out this blog post for more info. 

 

Active investing not for you? Passive investing (a.k.a. the long-term strategy) might be a better fit.

 

What is passive investing?

 

 

Passive investing is a buy and hold strategy that involves less buying and selling than active investment strategies. The goal is to build wealth gradually, so passive investing typically means investing your money in an account that closely follows a benchmark and leaving it alone to grow. Think of the saying, “slow and steady wins the race.”

Unlike active investors, passive investors aren’t seeking profits from short-term fluctuations in the market. The assumption here is that the market will grant positive returns over time, so it’s not necessary to react to short-term fluctuations to turn a profit.

However, it can still be tempting to try to cash in on spikes in stock prices, or to abandon ship when prices drop. That’s why self-discipline is key for the passive investor.

 

The cost of passive investing

Passive investing doesn’t require you or a portfolio manager to monitor investments daily or weekly. Instead, you’re taking a set-it-and-forget-it approach. The upside of this strategy is less management and commission fees – and potentially less capital gains tax.

 

What about risk?

Passive investing is typically considered less risky than active investing because you’re usually investing in collections of securities — hundreds, if not thousands of stocks or bonds at once – by choosing to invest in index funds or ETFs. This provides the benefit of diversification, which decreases the likelihood of taking a big loss with one investment.

However, passive investing may not offer the same level of returns as active investing, because this strategy is designed to mirror the market, not beat it. Passive investors ignore short-term fluctuations (which could potentially offer big returns) in order to keep assets for the long haul.

It can also take time to see large rewards – if you do see them at all. Even if you hold an asset for 10 years, you’re not guaranteed a huge return for your time. There’s always the possibility of buying and holding securities that don’t do as well as you thought they would.

Still, buying and holding can provide substantial gains in the long run because you’re weathering market volatility — you’re not selling with the ups and downs of the market to make a profit in the short term, but allowing your investments to grow steadily over time.

 

Passive investment strategies 

 

 
Index funds

Index funds, which aim to match the average returns of the index they’re tracking, are the most common form of passive investing. A stock market index records the performance of a group of stocks to demonstrate how a specific section of the stock market is doing – and an index fund allows you to invest in all (or most of) those stocks at once.

The performance of the fund compared to the index is monitored by a fund manager to minimize tracking errors. A tracking error is the difference between the fund’s value and the index it’s tracking. However, the fund manager can’t deviate from the index by trading securities — portfolios of index funds can only change substantially when the index they’re tracking changes. Because the fund manager isn’t actively trading securities, this is still considered a passive investing strategy (although actively managed index funds also exist). 

 

Exchange-traded funds (ETFs)

ETFs, as we’ve already mentioned, are a bundle of securities that usually tracks an index or industry sector. ETFs are bought and sold on stock exchanges just like regular stocks and typically offer lower commissions and fees than buying stocks individually.

Passive ETFs don’t require a fund manager to actively buy and sell stocks – meaning that their management fees are typically low. ETFs are a very accessible investment option – you can invest in ETFs on Flahmingo for as little as $1 (and with zero commission fees). 

 

Buying and holding directly

Funds and ETFs aren’t the only ways to passively invest. Simply holding stocks and other securities long term also counts as a passive investing strategy. You do lose the diversification that funds bring, but the risk is still lower than actively trading and the gains can be significant over time. For example, if you’d bought shares of Apple when they released the first iPod and held onto those shares until today, you’d have made quite a bit of money with little effort or time spent analyzing the market.

 

So which strategy is best for me?

 

 

At its core, passive investing maintains that good things come to those who wait – it’s all about a long-term perspective. This strategy doesn’t require as much time spent monitoring the market – it’s great for investors with long-term goals who prefer to be hands-off.  

Investors looking for higher profits in the short term may prefer an active strategy. However, active investing requires consistent attention, can be riskier, and usually involves additional costs and fees. 

Neither strategy is objectively better than the other – it all comes down to your personal investment goals. Additionally, active and passive investing don’t have to be mutually exclusive strategies. A combination of the two, which balances the stability of a long-term strategy with the potential gains of a short-term strategy, might be an approach that works for you.

To make the comparison even easier, we’ve compiled everything we just said into the following table.

 

active vs passive blog timetable copy (1)

Melissa Atefi

Author