Is Passive Investing Better Than Active Investing?

Active investing

As the name implies, active investing is the process of frequently buying and selling securities in order to try to beat standard market returns. Active investors try to find undervalued stocks that they can buy cheap and cash in when the stock performs to its true value.

This strategy requires a strong understanding of the market, as well as the ability to analyze investments using things such as financial statements. You can try to be an active investor yourself, or invest in actively managed mutual funds and ETFs that are managed by investing professionals.

Passive investing

Passive investing is a much more hands off approach that focuses on buying and holding a diversified portfolio over the long haul. Unlike active invesing that focuses on finding individual stocks that could be winners, passive investing is betting on the overall performance of the market given enough time.

For this reason, most passive investors will buy shares of index funds and ETFs that track the market so that they can set it and forget it. A passive investing strategy does not require the daily attention that an active investing strategy does.

Potential for high returns

If you are able to successfully research, find and buy undervalued assets at the right time, active investing does have the potential to yield higher returns than a passive investing strategy. Higher returns can tempt many investors into trying to become an active investor, but it does take a tremedous amount of skill to successfully execute.

More control over investments

Since you are the one who is choosing your investments, you do get the benefit of having more control over what you invest in. You can decide the exact stocks, bonds, and funds that you want in your portoflio. If you enjoy actively watching and following the market, having the ability to control your investments can be a nice benefit.

Very challenging to beat the market

It is extremely challenging to consistently beat the standard return of the market. Even many professional investors who are actively managing funds can struggle to consistently beat the return of the market. Now that is not to say that you can't try to employ an active investing strategy or buy actively managed funds, but you should be aware of the challenges it presents.

Requires lots of skill and time

Since active investing is such a challenging strategy, it requires lots of skill and time to master. Finding one stock that could be a winner could quite literally take days. The average every day investor simply does not have the time or the skill required to become an active investor.

Tax bills and fund expenses

Although most brokers don't charge commissions for stocks and ETFs, active investors are still subject to pay capital gains tax on their net gains. Since you are frequently buying and selling so many securities when you use an active investing strategy, it can create a large tax bill which can be a headache.

Additionally, you can incur higher fund expenses if you decide to outsource your active investing strategy to the professionals who actively manage funds. When you consider that these actively managed funds don't consistently beat passively managed funds, it does not make much sense to pay the extra fees.

Provides stable returns over time

Passive investors tend to experience positive returns over the long haul since they are not trying to beat the market, but instead follow the market. The S&P 500, which is commonly used to guage how the stock market is doing, has averaged a return of about 10% over the long term.

If you were simply to consistently make contributions into a index fund that tracks the S&P 500, you could capture this 10% return simply by buying and holding. Keep in mind that the stock market does crash so you have to develop a long term vision when you adopt a passive investing strategy.

Easiest way to invest

Passive investing is easy. Unlike active investing, you do not have to choose your own investments or spend hours researching to try to find one winning stock. You can simply set it and forget in when you invest in passive index funds, mutual funds, and ETFs.  

Lower costs

Unlike active funds which require higher fees to pay the professionals that manage them, passive funds tend to have lower costs since they simply track the market. Passive funds don't require much upkeep and don't have high trading volumes which can make passive investing more affordable than active investing.

Less control over investments

Passive investing does not give you the same control over your investments that active investing does. You do not get to choose the specific stocks that make up your funds. However, for the average every day investor, this is not that big of a deal.

Potentially missing out on higher returns

Although passive investing does provide stable returns, it is the return of the market. You are not ever going to beat the standard return that the market provides when you opt to use a passive investing strategy. However, as we previoulsy mentioned, this is not a bad thing as it can be almost impossible, even for professionals, to try to beat the standard return of the market.

The bottom line is this: For the every day investor, passive investing is the better strategy. It is easier, provides stable returns over time, is less stressful, and can be cost efficient. However, that is not to say that active investing is bad.

You could be an investor who enjoys taking the time to research your own investments and does not mind the challenges associated with active investing. If you do decide to try active investing, it is still probably best to allocate most of your portfolio to passive investing, and only allocate a small percentage towards active investing.