Investment strategies come in many forms and can be tailored to suit a range of investor personalities, preferences, and financial goals. Overall, these strategies fall into one of two general categories: active vs. passive investing.
Choosing an investment strategy depends on the investor’s goals as well as their comfort and risk level in the market. Here’s a look at the difference between active and passive investing, and why investors would choose either strategy.
What is active investing?
As its name implies, this type of investing requires an active approach from investors. Active investing involves frequently buying and selling stocks in an attempt to beat the market. This is also known as “timing the market.” If successful, investors are able to generate greater growth than the market, over a given period of time.
An active approach can have the following benefits:
- Personalization. Active investing allows investors to build a portfolio that is customized exactly to their interests, preferences, and passions. It also accounts for personal factors such as risk tolerance (which will shift over time) as well as goals and return objectives.
- Responsiveness. Active investing allows for a more tailored response to market shifts. In an extreme downturn or financial crisis, for instance, an active investment portfolio can be adjusted to reduce risk and exposure. Active investors may also be able to notice short-term opportunities, and make a transaction to capitalize.
However, there are downsides to consider.
- More opportunities for loss. Though active investing can offer short-term gains, it can also be a much more volatile approach to investing and introduces more opportunities for loss.
- Rarely exceeds benchmarks. Although investors may be able to successfully outperform passive market benchmarks some of the time, it’s unlikely they will be able to outperform those benchmarks all of the time.
- High effort. Active investors must concern themselves with buying, selling, and researching investments. Missing a major market move can be an expensive lesson, so investors usually watch and make changes on a regular basis.
Active investors generally manage their own portfolios via a brokerage account. There, they are able to buy or sell publicly traded investments as desired, based on current market conditions.
What is passive investing?
Passive investing requires minimal day-to-day effort. For many investors, this could mean buying stocks or funds and holding onto them for years, with the goal of long-term growth.
A common passive investment approach is to buy index funds—such as the S&P 500. These investment returns are generally stable, albeit slow. Although gains are not guaranteed, the average historical stock market return has been about 7% a year after inflation.
Here are some other advantages that can come with a passive approach to investing:
- Minimal effort. Passive investing is generally less work than active investing. Passive investors may simply “set it and forget it.” They can still rebalance and even adjust their portfolios for new goals, but typically don’t make many changes.
- Generally lower risk. In general, a passive investment strategy tends to be less risky than an active strategy, because it doesn’t attempt to time the market. What it does require from investors is patience and time.
- Some personalization. Passive investments can be tailored to an investor’s own preferences, though not as precisely as the typical active investment. For instance, passive investors often opt to buy mutual funds or exchange-traded funds (ETFs), which combine an entire portfolio of investment types to manage risk and boost growth. These funds can be adjusted for things like target retirement dates or even personal interests. However, these funds don’t offer the same direct personalization as buying a specific company’s individual stock.
There is, however, a potential downside.
- Not attuned to short-term opportunities. Passive investors may miss opportunities for short term gains that come from market moves or trends. Many robo-advisor and brokerage platforms (which passive investors often use) also don’t enable individual stock trading.
Passive investors might choose to build their portfolio through a brokerage account, opt for a managed investment solution, or use a robo-advisor to constantly oversee and rebalance their investments.
Active vs. passive investing
There are a few important differences to keep in mind when it comes to active vs. passive investing.
- Level of effort: Perhaps the most obvious difference between the two investment strategies is the level of energy and hands-on effort that each requires. As their names suggest, active is active while passive is passive.
- Averages vs. timing: Passive investing is about averages, whereas active investing is about timing. A passive investment strategy is one that intends to ride out market downturns and average the losses with growth over time. Investors generally don’t fret over weekly or even monthly market changes, instead focusing on years (or decades) of trends. Active investments, however, are all about buying low and selling high.
- Long view vs. short term: Passive investing usually takes the long view; active usually focuses on the short term.
Choosing between an active or passive investing strategy
So, how does an investor choose an approach? It comes down to personal preference. Investors might choose a passive route if they prefer a hands-off approach and are looking for long-term steady growth while potentially reducing risk and the effects of market downturns. Others may prefer active investing if they enjoy a hands-on process. Although this strategy is often more volatile, it allows for greater portfolio personalization, market-specific investments, and may offer faster returns if timed properly.