Understanding the Difference Between Active and Passive Investing


Here’s a simple look at the differences between active and passive investing. The latter is the more popular approach; however, active investing comes with its own unique benefits.

Either type of investing is better than none

If the current 40-year high level of inflation shows us anything, it’s that the value of the dollar is evaporating right before our eyes more quickly than ever.

Inflation had previously averaged 2.41% a year in the last decade, but currently, it’s at a record high of 8.2% for the 12 months ending September 2022.

You could tuck all your money away in a savings account for ten years, but unless it is earning interest, it is losing value year after year.

Investing your money in a low-risk asset will, at the very least, offset some of the losses in value due to inflation.

On the other hand, you might be able to break even or even surpass the cost of inflation by engaging in either passive or active investing.

What is passive investing?

Passive investing is a strategy of buying and holding long-term investment assets while involving minimal trading on the market. The most common type of passive investing is indexed investing. These exchange-traded funds, or ETFs, track major indexes such as the S&P 500.

Diversification is the key to successful passive investing, so aim for a well-diversified portfolio via indexing.

A typical strategy for passive investing is not aiming to beat the benchmark but only tracking it. For example, a passive fund investing in US stocks might buy all the stocks in the S&P 500 in the same proportion as the index, something that isn’t labor intensive and can also be automated, according to Kiplinger.

Therefore, most of the time, an investor will get a better return through passive investing while paying less for doing so. This method does not have numerous fees for training and overall active management.

Studies have shown passive investments have historically earned more money than active investments and have become more popular recently, particularly during market upheavals.

The downside of passive investing is that funds are limited to a specific index or predetermined set of investments. Further, passive funds never beat the market and never see the big returns that active managers can achieve (although those rewards come with a greater risk).

What is active investing?

Just as it sounds, active investing is hands-on and is often handled by a portfolio manager or other type of active participant, not necessarily you, although you can be. However, most of us don’t have the time to research, buy, and sell individual shares for our portfolios, and that’s why we hand this task off to a manager.

Active investing will have a greater focus on short-term profits, which means more frequent trading, buying, and selling. Rather than simply tracking a benchmark index, an active portfolio would buy assets based on company earnings or some other fundamental approach, according to Investopedia.

Active investing has benefits such as allowing portfolio managers to align with prevailing market conditions and reducing risk and exposure while maximizing gain. It also allows investors to take advantage of short-term opportunities. Lastly, through diversification, a portfolio manager might invest in an active long/short strategy to improve returns.

On the downside, active investing is more costly due to fees from potentially numerous transactions, as well as a management fee.

Further, active investing may be more difficult for some new investors to participate in. Some active funds set minimum investment thresholds. For example, new investors may be required to make a starting investment of $250,000.