Understanding the Difference Between Active and Passive Investing
Whether you are working with an advisor or doing your own investing, it is important to know the fundamental difference between two types of investing: active and passive.
Active investing is following investment trends and buying or selling as investments rise and fall. This takes a lot of time and attention. The goal is to “beat the market” and outperform specific standard benchmarks.
With this approach, financial advisors actively invest client assets through:
- Mutual funds: investment programs funded by shareholders that trade in diversified holdings and are professionally managed
- Exchange-traded funds (ETFs): pooled investment securities that operate like a mutual fund. Typically, ETFs will track a particular index, sector, commodity or other asset, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way a regular stock can
- Portfolios of stocks, bonds and other holdings
The idea of active investing is if things go well with your investments, you might be able to outperform the market. This is possible even if you pay your advisor or broker a higher fee for this hands-on approach. But performance is never guaranteed.
Considerations for Active Investing
Your advisor or team of advisors may be picking individual stocks or market sectors in which to place your money.
Having an advisor or advisory firm actively manage your portfolio in this way can incur higher fees than following a passive strategy. You would want to beat the market by a certain percentage to make paying the higher fee worth it.
The main risk of active investing is that you or your portfolio manager may not add value compared to a passive fund—and may even provide worse returns.
When practicing passive investing, you want to maximize your returns with a minimum of buying and selling. With this strategy, you might buy and hold stocks and bonds in:
Passive funds or passive index funds: these seek to replicate the performance of their benchmarks instead of outperforming them. For instance, the manager of an index fund that tracks the performance of the S&P 500 typically buys a portfolio that includes all of the stocks in that index in the same proportions as they are represented in the index.
Considerations Passive Investing
You may pay lower fees for this type of investing, because it doesn’t involve such a hands-on human component.
This approach is also more transparent. You will know exactly what stocks and/or bonds your indexed investment contains. There is a consistency that is comforting to some investors as they work steadily toward their long-term financial goals.
The main risk of investing via a passive fund is that you might over-expose yourself to a small number of sectors or stocks. Because passive funds are skewed to automatically follow the most well-performing opportunities, their portfolios will often contain a small number of high-performing investments. Should these assets suddenly take a turn for the worse, they can cause the overall investment portfolio value to drop.
Which Is Right For Me?
Some people find a mix of active and passive investments is a good way to diversify their portfolios. With the lower fees involved, passive investing is better for those who don’t have the time or desire to actively manage their investments—or can’t hire someone to do it for them.
Your decision will likely come down to:
- Your priorities
- Your desired personal involvement in managing your money
- Your long-term goals
If you are unsure what direction to take, an investment advisor can explain your options and provide guidance.
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