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Passive investing and active investing are two contrasting strategies for making your money work in the markets. Both rate their success against common benchmarks like the S&P 500, but active investing generally seeks to beat the benchmark, while passive investing aims to duplicate its performance.
What is active investing?
Active investing is a strategy that involves frequent trading, usually with the aim of beating the average returns of the index. This is probably what you think of when considering traders on Wall Street, although these days you can do it from the comfort of your smartphone using apps like Robinhood.
âThis type of investment usually requires a high level of market analysis and expertise to determine the best time to buy or sell. [investments]Says Kevin Dugan, investment advisor and senior partner at Dugan Brown, a financial planning firm in Dublin, Ohio.
You can make active investments yourself or have them professionally done through actively managed mutual funds and active exchange traded funds (ETFs). These provide you with a ready-made portfolio of hundreds of investments.
Active fund managers assess a wide range of data about every investment in their portfolios, from quantitative and qualitative data on securities to broader market and economic trends. Using this information, managers buy and sell assets to capitalize on short-term price movements and keep the fund’s asset allocation on track.
Without this constant focus, it is easy for the most meticulously crafted actively managed portfolio to fall prey to volatile market swings and accumulate short-term losses that can impact long-term goals.
This is why active investing is not recommended for most investors, especially when it comes to their long-term retirement savings.
Benefits of active investing
- Flexibility in volatile markets. “The active investor has the potential to switch to a defensive position or asset, such as cash or government bonds, during bear markets to avoid catastrophic losses,” says Brian Stivers, investment advisor and founder of Stivers Financial Services in Knoxville, Tenn. , investors can also reallocate to hold more stocks in growing markets. By reacting to market conditions in real time, they may be able to beat the performance of market benchmarks, like the S&P 500, at least in the short term.
- Extensive trading options. Active investors can use trading strategies such as hedging with options or short selling stocks to generate windfall profits that increase the chances of them beating market indices. However, these can also dramatically increase the costs and risks associated with active investing, making them techniques best left to highly experienced professionals and investors.
- Tax management. A wise financial advisor or portfolio manager can use active investing to execute trades that offset gains for tax purposes. This is called harvesting tax losses. While you can certainly use tax loss recovery with passive investing, the amount of trading that takes place with active investing strategies can create more opportunities and make it easier to avoid the sell-off rule. White.
Disadvantages of active investing
- Higher fees. These days, most brokerages do not charge trading fees for day-to-day purchases of stocks and ETFs. But more sophisticated trading strategies based on derivatives can incur costs. And if you invest in actively managed funds, you will have to pay high expense ratio fees. Due to research and the number of transactions involved, actively managed funds have relatively high expense ratios, averaging 0.71% as of 2020.
- Increased risk. When active investors are right, they can win big. But if an investment zigzags when you zigzag, it can reduce portfolio performance and lead to catastrophic losses, especially if you’ve used borrowed money – or margin – to place it.
- Exposure to the trend. In active investing, it’s very easy to jump on the bandwagon and follow trends, whether it’s memes actions or pandemic-related exercise patterns. Consider the investor who decided to jump into the home workout trend and buy Peloton (PTON) at $ 145 on January 4, 2021. As of early November 2021, this stock is now trading in the 50’s. $ due to the relaxation of pandemic restrictions. made home workouts easier. What gets very difficult with trend-based investing is figuring out if you are at the forefront of the trend or if there is still room to grow.
What is passive investing?
Passive investing is a strategy focused on buying and holding assets for the long term. It’s best described as a hands-off approach: you pick a stock, then hang on to the ups and downs with a longer term goal, like retirement.
While active investing tends to focus on individual stocks, passive strategies typically involve buying stocks of index funds or ETFs that aim to replicate the performance of major market indices, such as the S&P 500. or the Nasdaq Composite. You can buy shares of these funds in any brokerage account, or you can have a robot advisor do it for you.
Because it is a set-and-forget approach that only aims to match market performance, passive investing does not require daily attention. Especially when it comes to funds, this results in fewer transactions and considerably lower fees. This is why it is a favorite of financial advisers for retirement savings and other investment goals.
Benefits of passive investing
- Lower costs. The reduced trading volumes associated with passive investing can lead to lower costs for individual investors. Additionally, passively managed funds charge lower expense ratios than most active funds because they require very little research and maintenance. The average expense ratio for passive mutual funds in 2020 was 0.06%; passive ETFs came in at 0.18%.
- Decreased risk. Since passive strategies tend to be more fund-oriented, you typically invest in hundreds or even thousands of stocks and bonds. This allows for easy diversification and reduces the likelihood that an investment will turn sour and deplete your entire portfolio. If you manage an active investment yourself and lack proper diversification, one bad move could wipe out substantial gains.
- Increased transparency. What you see is what you get with passive investing. In fact, the index tracked by your fund is often part of its name and it will never hold any investments outside of its namesake index. Actively managed funds, on the other hand, do not always offer this level of transparency; much of it is left to the discretion of the manager and some techniques may even be hidden from the general public to preserve a competitive advantage.
- Higher average returns. If you are investing for the long term, passive funds of any kind almost always offer higher returns. Over a 20-year period, around 90% of index funds tracking companies of all sizes outperformed their active counterparts. Even over three years, more than half have done so, according to the latest S&P Indices Versus Active (SPIVA) report from S&P Dow Jones Indices.
Disadvantages of passive investing
- It is not flashy. If you’re looking for the excitement that comes with skyrocketing rapid returns from a single stock, then passive investing is nothing in comparison.
- No exit strategy in severe bear markets. Because it’s designed for the long term, passive investing doesn’t have an exit ramp during severe market downturns, warns Stivers. While historically the market has recovered from every correction, there is no guarantee that it will do so quickly. This is part of the reason why it is important to regularly review your asset allocation over a longer period of time. This way you can make your portfolio more conservative as you approach the end of your investment schedule and have less time to recover from a market downturn.
Should you choose an active fund or investment style?
Given that in the long run, passive investing usually offers higher returns with lower costs, you may wonder if active investing ever deserves a place in the average investor’s portfolio. For some types of investors, the answer may be yes.
Preservation of wealth
Investors who prioritize preservation of wealth over growth could benefit from active investment strategies, according to Stivers. For example, an active strategy might well serve a person nearing retirement who does not have time to recover from large losses or who is focused on building regular income instead of making regular capital gains on the job. long term.
Active and passive investing don’t have to be mutually exclusive strategies, Dugan notes, and a combination of the two could serve many investors.
Investors with both active and passive holdings can use active portfolios to hedge against declines in a passively managed portfolio during a bull market. A blended approach can also give an investor the peace of mind of knowing that their long-term passive strategy (like their retirement funds) is on autopilot while an active short-term strategy (like a taxable brokerage account). ) allows him to explore trends without compromising their long-term goals.