What is Active Vs Passive Investing?
What is the difference between active and passive investing?
What should you know?
In this article, we will break down the notion of Active Vs Passive Investing so you know all there is to know about it!
Keep reading as we have gathered exactly the information that you need!
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What Is Active Vs Passive Investing
You may have heard of the financial phrases active investing and passive investing.
Do you know what is the difference between active versus passive investment strategies?
In a nutshell, active investing is a type of investment strategy that is aimed at actively managing investments in a portfolio with the objective to generate a return.
In this context, portfolio managers will regularly evaluate the stocks, bonds, and investment assets held in a portfolio to determine if it may be worth selling some and buying others.
On the other hand, passive investing is a type of investment approach where the investor invests his or her money into certain instruments or assets and keeps them for a longer period of time.
The objective of a passive investor is to generate a return by buying and holding securities, stocks, bonds, or assets.
What Is Active Investing
Active investing is a type of investment strategy where someone like a portfolio manager, an investment advisor, or a financial professional actively manages a certain sum of money, capital, or investment portfolio.
You can actively manage funds, investment portfolios, mutual funds, or other invested assets.
Actively managed funds or investments are those where the portfolio manager’s objective is to take advantage of price fluctuations in the market to generate a return to the investors.
Typically, the investment professional is highly knowledgeable in investments, performs regular and thorough analysis of the market, the market risks, and potential returns.
Many active portfolio managers will evaluate investment opportunities by considering the qualitative value of the investment along with quantitative factors to forecast what may be a suitable investment.
What Is Passive Investing
Passive investing, on the other hand, is a type of investment approach where the investor is not looking to take advantage of price volatility in the market, perform a deep analysis of different investment instruments, and spend a lot of time and energy deciding what assets to keep and what to sell.
Rather, a passive investing approach is one where the investor invests in stocks, bonds, real estate, or assets for the long term.
The investor’s goal is to generate a profit or return by keeping the securities or asset based on the expected long term appreciation in its value.
For example, a person many invest in rental revenue properties to generate a steady stream of rental income for many years and eventually sell the real estate property for a profit.
This is a passive investment approach as once the investment is made, the effort to maintain the investment is little in comparison to the expected returns.
Active Vs Passive Investing Differences
What are the differences between active and passive investing?
In general, active investing involves:
- A higher level of flexibility to buy and sell securities
- The ability to hedge risk by using more complex and advanced investment strategies such as short selling or investing in derivatives
- Will require the portfolio manager to be mindful of the tax consequences of selling securities for a profit and generating capital gains versus selling at a loss and generating a capital loss
- Managing a portfolio actively is going to be much more costly due to the management fees charged by the financial professionals, the transaction costs, and the overhead required to investigate, research, and analyze investment options
- The active management of risk meaning that if a particular security becomes risky over time, they are free to sell it off and purchase another security
On the other hand, passive investing involves:
- The purchase of certain securities for the long term adopting a “buy and hold” investment approach
- The investor will not incur important management fees, transaction cors, or other overhead costs to manage the investment, as such the investor pays very low fees
- The investor does not have to actively spend time analyzing the investment risks, returns, and following the market to make quick investment decisions
- There is a higher level of tax efficiency as the investment instruments are not constantly being purchased and sold triggering tax consequences, capital gains tax, or losses
- The investor does not have a lot of flexibility in investment strategies, techniques, and options to hedge risk or pivot in case the market conditions change rapidly
- Since the investor is not taking as much risk as an active investor, the expected returns are going to be lower
Active Vs Passive Investing Pros And Cons
Here is a list of pros and cons of active v passive investing:
Active Investing Benefits
- More investment flexibility where the portfolio manager can buy and sell different types of stocks, bonds, and securities
- Ability to manage risk by opening and closing trade positions based on the market conditions
Active Investing Drawbacks
- Higher management fees as the portfolio managers need to be paid, their staff salaries must be paid, their offices, overhead costs, research costs, and so on
- Higher transactional costs as the managers will perform lots of trades to buy and sell various securities
Passive Investing Benefits
- Lower fees as the passive investment strategy does not require a lot of research and market evaluation to pick a particular stock, bond, or asset, or will it require a team of professionals to make investment decisions
- Lower transactional costs as the premise of passive investing is not to trade frequently but rather keep the investment for a long investment horizon
- Tax efficiency as the investor does not need to keep track of what securities generated a capital gains and which ones a capital loss for tax reporting purposes
- Greater transparency as the investor has a clear understanding and knowledge of what investment instruments are held in the portfolio
Passive Investing Drawbacks
- Less control over the portfolio composition as the passive investor will typically buy into a collection of securities like an index or fund
- Smaller returns as the investment approach is to earn a return similar to the market performance, the objective is not to outperform the market
Active Vs Passive Investing Examples
What are some examples of active and passive investment?
A good example of active investing is a hedge fund.
A hedge fund is a pool of investment funds trading liquid assets and adopting very complex and sophisticated trading strategies in an attempt to manage risk and generate higher returns.
They will purchase stocks, short sell, perform financial leverage, purchase derivatives such as call options and put options, and more.
To manage a hedge fund, the hedge fund manager must be highly alert to market conditions and be ready to quickly trade one investment position for another, to open a new investment position or close other positions.
On the other hand, an example of passive investing is the investment in a dividend stock.
When an investor purchases shares in a single company having a long track record of issuing dividends and for the long term, the investor is said to adopt a “passive investment” strategy.
The idea of the investor’s passive investment approach is to keep the dividend-paying stock for a long time, cash in the dividends or reinvest them to buy more stocks in the same company, and eventually sell the stock for a price higher than the initial purchase price.
You can also consider investments in index funds such as the S&P 500 or the Dow Jones Industrial Average, or buying and holding index-style stocks, bonds, and instruments, to be passive investing.
The reason why the investment is passive is that you are buying and holding an index (which is a representation of the market or a particular sector) and hoping to generate a return similar to what the market offers on average.
Your goal is not to actively buy and sell securities but keep your index fund investment for the long term.
Combining Active And Passive Investing Strategies
For many investment professionals and investors, the notions of active and passive investing strategies are not mutually exclusive.
They do not consider that they need to favor one strategy over another.
In reality, many consider that the most effective investment strategy is the combination of active and passive investing approaches.
For example, depending on the market conditions, certain an active versus passive approach may be preferred.
If the market is volatile, there’s economic uncertainty, and the economy is weakening, an active investment approach may generate more returns than a passive one.
On the other hand, if the market is stable, stock prices move in a stable pattern, equity valuations are uniform, and the market is getting stronger, a passive approach can provide a good return to investors.
Pure active investing requires research, investment knowledge, sophistication, and the willingness to trade quickly whereas pure active investing is based on a buy-and-hold investment strategy.
By combining the two, you are effectively benefiting from the flexibility to open or close a position on a stock, bond, or investment as needed, you are mindful of the market conditions, you assess opportunities as they come, and you have some money invested passively generating you returns.
Active vs Passive Income
Now that we’ve seen the main characteristics and meaning of “active investing” vs “passive investing”, you may ask yourself the question: what about active versus passive income?
Active income is a type of income that you can expect to receive by actively performing certain work, rendering services, or doing a job.
In other words, you are actively doing something that allows you to generate an income.
For example, an employee will actively work to earn a salary (an income).
A service provider will actively render services to generate business income.
Passive income, on the other hand, is a type of income that you can generate without actively or materially spending time and effort when the initial passive income generating source has been set up.
To generate passive income, you will likely need to either spend time to build a structure allowing you to earn passive income or invest money and capital to acquire a source of passive income.
For example, you can use your money to buy a real estate property giving you a steady stream of passive income over time.
You can also, like myself, start a blog by putting in your time and energy with the objective of generating passive income through advertisement income, affiliate marketing, selling digital products, and other passive means to generate cash.
My blog here is dedicated to the topic of generating passive income and how you can build wealth for yourself over time, you are invited to check it out as you may find something that may inspire you.
Active Investing Vs Passive Investing Takeaways
So, what does “active investing” and “passive investing” mean?
What differentiates an active from a passive investment approach?
Let’s look at a summary of our findings.
Active Vs. Passive Investing
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