Every investor’s strategy and portfolio is different, and can be based on a variety of individual factors like their goals, lifestyles, and appetite for risk. But overall, investment strategies fall into two categories: active and passive investing.
Active investing can be an appealing strategy for investors who love keeping up with market moves—or select an investment manager to do so—and are willing to weather additional volatility and risk for the potential of higher returns. It’s a buy-and-sell strategy that lives up to its “active” moniker.
What is active investing?
Active investing is a strategy that involves frequent action from investors or their portfolio managers, who buy and sell stocks often in a bid to achieve growth greater than that of the broader market. They constantly monitor market conditions to try to find opportunities—like buying shares of a buzzy company—and if active investors can “time” their investments successfully, they may beat the market’s growth over time.
Active investors take an opposite approach to passive investors, who adhere to more of a “set it and forget it” or “buy and hold” mentality. This often means buying stocks, exchange-traded funds (ETFs), or index funds—like those that track the S&P 500—and holding onto them for years with the goal of growth over the long term. It’s a lower risk strategy than active investing, but the potential for growth is also more limited. Though gains aren’t guaranteed for any given strategy, these passive investments have historically garnered slow-and-steady growth: The average stock market return is about 7% each year, adjusted for inflation.
Potential advantages of active investing
Active managers looking to make short-term investments can consider several potential benefits:
- An individualized portfolio. The active strategy gives investors complete flexibility to choose what they want to invest in. Because they’re not tied to specific investments like mutual funds or other selections they plan to hold onto for a while, they can put their money wherever and whenever they feel there is an opportunity for growth. Their portfolios change frequently, so they can customize their investments to their individualized interests, desire for risk management, and personal finance goals. These considerations can change over the course of an investor’s life, and active investing allows them to tweak their approaches as needed.
- Ability to respond to the market quickly. Sentiment in the broader market can shift, as can the movement in specific stocks and other investments. Active strategies allow investors to respond immediately—for example, changing their approach when the market is on a tear or in a downturn, or identifying opportunities for short-term growth. They allow investors to quickly sell off or buy any given stock to capitalize on opportunities, which passive investors might miss.
Potential limitations of active investing
Though active investing may have potential advantages over passive investing, it also comes with potential limitations to consider:
- Requires high engagement. Active investors have to stay informed about the broader market as well as specific investments. That can be a lot of day-to-day work (which is why many investors outsource this to wealth managers), but active investors don’t want to miss a big market move or other opportunities for growth.
- Demands higher risk tolerance. Done successfully, active investing can reap high growth in a short period. But the flip side of this greater opportunity is greater risk. Because active investing hinges on short-term moves, it is by its nature much more volatile.
- Tends not to beat benchmarks over time. Successful active investors may beat the market sometimes. But it’s unlikely they will every time. Studies show that over the long term, growth in active investments tends to lag passive investment benchmarks.
Active investing vs. passive investing
Passive investing can be a strategy for investors who don’t want to commit to daily engagement and stay educated about ever-shifting market trends. If an investor’s financial goals are long-term ones, such as retirement, the buy-and-hold approach may reward them with slow but steady gains without as much volatility.
Like active investing, those who opt for a passive strategy can create their own portfolios through brokerage accounts, or allow a portfolio manager or robo-advisor to select and oversee their investments.
Key difference: taxes
One major differentiator of active vs. passive strategies to consider is their tax implications. While both are subject to capital gains tax, they are levied at different rates.
With passive investing, holding onto stocks for a longer period (more than 1 year) typically triggers long-term capital gains tax, which is generally lower than short-term capital gains, with rates falling into brackets based on taxable income levels: 0%, 15%, or 20%. The Internal Revenue Service says most individuals pay no more than 15% on these types of gains.
But if the asset is sold within a year, as happens often with active investing, profits are subject to short-term capital gains. That means an investor’s profits from that quick sale are taxed just like regular income—and the current top tax rate is 37%, according to the IRS.
Mixing passive and active investing
As with any investment strategy, both passive and active investing offer both potential advantages and potential limitations. But the choice isn’t binary: Investors can easily combine passive and active investments in their portfolios.
For example, they may opt to become more active in a downturn, identifying opportunities to “buy low” in stocks they believe will recover when the market levels out, and then return to a more passive balance when the broader recovery comes. Or investors may opt to put some cash in steady index funds, and reserve some for targeted investments in certain sectors like technology.
The bottom line
An active investing strategy requires investors (or their portfolio managers) to be engaged constantly, staying educated on market shifts and frequently buying and selling stocks to try to beat the market. Passive investing is a “buy and hold” model, in which investors hold onto stocks, funds, and other assets for years to try to achieve slower but stable growth. Investors can opt for a mix of active and passive strategies to balance potential reward with potential risk.