Passive vs Active: How easy should investing your money be?5 min read

Passive vs Active Investing - Actionable Finance

When you’re first starting to look at investing you will probably have stumbled across the terms passive investing and active investing. In this post we’re going to help you understand these terms and decide which approach may be right for you.

Active Investing

Active investing is a hands on approach to investing with it’s aim being to beat the average market return. This term is most often seen when describing funds which are managed by experienced traders (active management). This can be a positive as you are able to delegate the decision making however you are still reliant on that experts choices.

You can participate in active investing on your own by picking your own stocks and then managing your portfolio by yourself. This of course is a more time consuming option and potentially riskier if you do not have a lot of financial expertise.

How do they try to outperform the market?

There are multiple ways they can attempt to beat the market average.

 

  • More frequent buying and selling of stocks to capitalise on shorter term gains.
  • Trying to time investment decisions.
  • Picking investments that differ from the index they are trying to beat.
  • Weighting these assets differently from their benchmark index.

Passive Investing

The other choice is passive investing, where you invest in a fund which tracks an index. This means you are targeting an average market return and not trying to outperform it. These index benchmarks have a strong historic record of gaining value over time. Although this is not an indication of future gains it does provide confidence and potentially lower risk for the average investor. 

Passive strategies are best suited to longer time horizons as they are usually associated with buy and hold investments. Their lower fees also allow further compounding over this period. This means they are well suited to pensions and other retirement funds where you invest every month no matter the market conditions. This can help automate investing so it takes up little of your time and can remove decision making, helping to relieve stress.

Passive Vs Active

Lets have a look at where these two strategies differ.

Summary of Passive vs. Active Investing

Passive
Active
Returns targeting the market average.
Returns aiming to beat the market (could not).
Less Flexibility
More Flexibility
Fees are usually low
Fees are generally higher
Time efficient
Time Consuming
Potentially less risk and stress.
Potentially more risk and stress.
Returns

The main pro for active investing is the potential for higher rewards and out performing the market. If the stock picks which you or your fund manager chose succeed, you could outperform the market. The main issue is the likelihood of this happening on a consistent basis being quite low.

As you should know by now stocks and shares are guaranteed to go down as well as up especially on a day to day basis. By deviating from the index to unlock the potential of higher returns you are also unlocking the potential for lower returns.

As previously stated actively managed funds do beat the market occasionally. However when they do, the premium fees charged can negate this difference and even bring you below the average.

By being a passive investor you are locked into returns of around the market average so their potential ceiling is lower. Of course this will vary from person to person due to when they invested but on the whole you know if the overall market does well you will do well also. This results in the long term consistency required for creating wealth.

Flexibility

With passive investing you are locked into a certain way you can invest. You will only really be investing in index funds and will likely be holding for a long time. With active investing you have more choice on what you can invest in as you can go for individual stocks as well as funds.

Actively managed funds potentially have access to more specialised trading strategies such as shorting stocks or hedging. These can help increase gains and reduce the risk however are more complicated so will only really be found in very specialized active funds. You will likely pay a premium for these also which could negate the advantages. Whether these strategies will result in a better result in the long run is also not guaranteed.

Fees

Fees are one of the only things you can influence in investing as you can chose comparable funds with lower fees to access greater returns. This also goes for the investment platform or broker you use. Passive funds are especially well known for having low fees which means more of the profit stays in your pocket.

Actively managed funds however are priced at a premium due to the constant management and additional trading costs incurred. Obviously this depends on the fund but if you want an expert to manage your portfolio you will have to pay for it which will eat into your returns.

Time

Active investing requires a high level of financial expertise which if you are investing by yourself will be time consuming. Its also highly likely that even after all this research you may still not outperform the market as even experts cannot do this consistently. 

This time loss can be averted by purchasing an actively managed fund or a passively managed fund. Do not overestimate this as time is one of your most powerful assets. Creating another income stream or working towards a promotion will likely result in a much greater reward than trying to beat the market by a percent or two.

Risk & Stress

Active investors deviate from an index introducing risk in the potential for more volatility and so a wider range of outcomes such as very high returns and very big losses. This can introduce more stress to your life which you most likely don’t need. Passive investing can negate this due to the long term buy and hold strategy where you invest no matter the market conditions. This can be a better option for most people especially retail investors. By helping to separate your emotions from investing you are far more likely to see a better return.

The Decision

Both strategies have merit and have resulted in good returns over the years. You may pick the passive strategy for its simplicity allowing you to not be fully involved with your investments. Then again you may want to and enjoy knowing all the ins and outs of your portfolio. You may also value the knowledge of expert fund managers enough to pay the higher fees. It all comes back around to how much risk and time you are willing to take.

Don’t go thinking you have to do one or the other either. Many investors have found success by using a combination of active and passive investments. One way could be to take your equity portfolio and dedicating 90% to passive investments and 10% to individual stock picks you have researched well. You could then change these percentages depending on how much you enjoy it. 

For beginners passive investing in index funds is a great way to start and I believe should be the bulk of all retail investors portfolios. They allow you to get used to market volatility whilst taking away many decisions. This generally sets you up for early and lasting success.

There is no right or wrong way to invest just remember that nobody knows what the future may hold and everyone will be slightly biased to how they invest. You just have to do your own research and see what’s right for you. I hope this has helped and happy investing!

Disclaimer

All information is not financial advice and is purely meant for educational purposes only. Investing involves the risk of loss of capital as well as its gain. Any investments mentioned on this website are meant as examples not specific recommendations. Always do your own research and/or gain the help of a financial advisor. 

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