Active vs. passive investing: which one is right for you?
Here’s how to help choose the right approach for your goals.
Article published: November 10, 2023
While everyone agrees that investing is one of the best ways to help grow your wealth and achieve your goals, not everyone agrees on how to do it. There are two primary approaches: passive and active investing. While a passive investor typically tries to match a market index or a combination of indexes, an active investor looks to beat that performance by taking advantage of short-term market fluctuations. But which approach is right for you?
Let’s take a closer look at active vs. passive investing to understand what they are, how they differ and how you can leverage each approach to develop your portfolio.
What is active investing?
Active investing strategies aim to outperform average index returns, usually through frequent trading and either high-level analysis of financial markets and/or fundamental analysis of individual securities (bonds or stocks). As such, active investors often rely on extensive research, accurate predictions and timing – making this a high-risk, high-reward approach. And because an active investment strategy uses a short-term, buy-and-sell approach, it can incur higher trading fees.
Due to the increased risk, time and cost involved with this strategy, many investors choose to use an actively managed fund as opposed to a DIY approach.
Active funds
In funds, you put money into a pool of funds that go toward a portfolio of securities. The active fund manager makes buy and sell decisions based on research, analysis and market insights. However, the high level of involvement with active management means that these funds tend to have higher costs without the guarantee of above-average returns.
What is passive investing?
Passive investing seeks to replicate the performance of a specific market index or segment by developing a portfolio to mirror its composition and diversity. Investors firmly planted in this camp tend to believe it’s too difficult to consistently outperform the market using active management. In contrast, a passive approach to investing uses a hands-off method that requires less research, monitoring and trading fees.
Passive funds
Passive funds can provide investors with a long-term, lower-cost approach to investing with portfolios based on the specific composition and returns of a chosen index. Index funds or exchange-traded funds are common options as they typically offer broad market exposure with lower management fees. As a result, passively managed funds can be used to diversify portfolios and save for retirement.
Active vs. Passive investing: key differences
Whereas active managers and investors may research, buy and sell securities each day, passive managers and investors are more often content with holding a diverse portfolio of investments to achieve their returns over a longer period of time.
Of course, this is the primary difference, but it leaves out a lot of the nuances between the two approaches. To gain a better understanding of the key advantages and disadvantages of each, let’s take a look at the pros and cons of active and passive management:
Pros of active management
- Active managers have the potential to earn returns that beat the index
- Active managers or investors are typically more flexible during volatile markets because they don’t follow a specific index
Cons of active management
- Active investing carries greater risk, especially when analysts are incorrect
- Trading daily or using an active manager may incur higher fees
- It can be too easy to hop on a trend or join a bubble just as it’s about to burst
Pros of passive management
- Passive investment strategies offer greater transparency because they follow a specific market index
- Passive management and investing require less trading, which can lead to lower expense ratios
- The buy-and-hold approach in taxable accounts can help add tax efficiency as they tend to generate fewer taxable events that could create capital gains
- It removes the emotional or subjective feelings of a fund manager from the process of investing
Cons of passive management
- Passive investing doesn’t have a manager making decisions about when to take more or less risk
- A passive fund will likely not beat the market in the short term
Which investment strategy is right for you?
Ultimately, the investment decision to go with an active vs. passive strategy will primarily depend on your specific goals, risk tolerance and financial position. If you have the time, expertise and appetite for risk, an active strategy could be a great way to help reach your goals. In contrast, passive investors tend to favor returns that are closer to an index over time – and they’re willing to wait for it, especially because they don’t want to spend too much time researching or trading. With any investment strategy, you should be prepared for the possibility (or inevitability) of underperforming in any given year.
Of course, the active vs. passive investing debate isn’t binary. In fact, some investors use both approaches in a single portfolio.
They aren’t mutually exclusive
Combining active and passive holdings into a single portfolio can allow you to get some benefits from fund manager skills while helping ensure that you still have opportunities from the overall direction of the market. This approach provides both an active strategy that can explore new opportunities and enable greater flexibility, and a passive strategy that can act as a steadier source of returns in the background.
At Edelman Financial Engines, we recommend our clients invest with retirement in mind. That typically means ensuring a diverse and balanced portfolio and focusing on long-term goals rather than short-term gains.
If you’re looking for professional investment guidance, reach out to one of our financial advisors today. They can work with you one-on-one to develop a solid strategy to help you meet your goals and grow your wealth.
Investing strategies, such as asset allocation, diversification or rebalancing, do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. All investments have inherent risks, including loss of principal. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Past performance does not guarantee future results.
