Active investing may sound like it’s a better approach than passive investing. After all, we’re prone to see active things as more powerful, dynamic and capable. Active and passive investing each have some positives and negatives, but the vast majority of investors are going to be best served by taking advantage of passive investing through an index fund.
Here’s why passive investing trumps active investing and one hidden factor that keeps passive investors winning.
What is active investing?
Active investing is what you often see in films and TV shows. It involves an analyst or trader identifying an undervalued stock, purchasing it and riding it to wealth. It’s true – there’s a lot of glamour in finding the undervalued needles in a haystack of stocks. But it involves analysis and insight, knowledge of the market and much work, especially if you’re a short-term trader.
Advantages of active investing
- You may earn higher returns. If you’re skilled, you can find higher returns by researching and investing in undervalued stocks than you can by buying just a cross-section of the market using an index fund. But success requires having an expert knowledge of the market, which may take years to develop.
- Fun to follow the market and test your skill. If you have fun following the market as an active trader, then by all means spend your time doing so. However, you should realize that you’ll probably do better passively.
Disadvantages of active investing
- Hard to beat professional active traders. While active trading may look simple – it seems easy to identify an undervalued stock on a chart, for example – day traders are among the most consistent losers. It’s not surprising, when they have to face off against the high-powered and high-speed computerized trading algorithms that dominate the market today. Big money trades the markets and has a lot of expertise.
- Most active traders don’t beat the market. It’s so tough to be an active trader that the benchmark for doing well is beating the market. It’s like par in golf, and you’re doing well if you consistently beat that target, but most don’t. A 2022 report from S&P Dow Jones Indices shows that more than 85 percent of fund managers investing in large companies underperformed their benchmark in the prior 12 months. And it’s nearly as bad over time, with more than 83 percent unable to beat the market over 10 years. These are professionals whose sole focus is to beat the market, ideally by as much as possible.
- Requires a lot of skill. If you’re a highly skilled analyst or trader, you can make a lot of money using active investing. Unfortunately, almost no one is this skilled. Sure, some professionals are, but it’s tough to win year after year even for them.
- Can run up a big tax bill. While commissions on stocks and ETFs are now zero at major online brokers, active traders still have to pay taxes on their net gains, and a lot of trading could lead to a huge bill come tax day.
- Requires a lot of time. On top of actually being difficult to do well, it actually requires a lot of time to be an active trader because of all the research you need to do. It makes little sense to spend more time to do worse unless you’re also actively trading for fun.
- Investors often buy and sell at the worst times. Due to human psychology, which is focused on minimizing pain, active investors are not very good at buying and selling stocks. They tend to buy after the price has run higher and sell after it’s already fallen.
What is passive investing?
In contrast, passive investing is all about taking a long-term buy-and-hold approach, typically by buying an index fund. Passive investing using an index fund avoids the analysis of individual stocks and trading in and out of the market. The goal of these passive investors is to get the index’s return, rather than trying to outpace the index.
Advantages of passive investing
- Beats most investors over time. Passive investors are trying to “be the market” instead of beat the market. They’d prefer to own the market via an index fund, and by definition they’ll receive the market’s return. For the S&P 500, that average annual return has been about 10 percent over long stretches. By owning an index fund, passive investors actually become what active traders try – and usually fail – to beat.
- Easier to succeed at. Passive investing is much easier than active investing. If you invest in index funds, you don’t have to do the research, pick the individual stocks or do any of the other legwork. With low-fee mutual funds and exchange-traded funds now a reality, it’s easier than ever to be a passive investor, and it’s the approach recommended by legendary investor Warren Buffett.
- Deferred capital gains taxes. Buy-and-hold investors can defer capital gains taxes until they sell, so they don’t need to ring up much of a tax bill in any given year.
- Requires minimal time. In a best-case scenario, passive investors can look at their investments for 15 or 20 minutes at tax time every year and otherwise be done with their investing. So you have the free time to do whatever you want, instead of worrying about investing.
- Lets a company’s success drive your returns. When you invest with a buy-and-hold mentality, your returns over time are driven by the underlying company’s success, not by your ability to outguess other traders.
Disadvantages of passive investing
- You’ll get an “average” return. If you’re buying a collection of stocks via an index fund, you’re going to earn the weighted average return of those investments. Meanwhile, you’d do much better if you could identify the best performers and buy only those. But over time, the vast majority of investors – more than 90 percent – can’t beat the market. So the average return is not so average.
- You’ll still need to know what you own. If you’re actively investing, you know what you own and you should know which risks each investment is exposed to. With passive investing you need to understand, broadly, what any funds are investing in, too, so you’re not completely disengaged.
- You may be slow to react to risks. If you’re taking a long-term approach to your investments, you may be slower to react to true risks to your portfolio.
Active investing vs. passive investing: Which strategy should you choose?
The trading strategy that will likely work better for you depends a lot on how much time you want to devote to investing, and frankly, whether you want the best odds of success over time.
When active investing is better for you:
- You want to spend time investing and enjoy doing so.
- You like doing research and the challenge of outguessing millions of smart investors.
- You don’t mind underperforming, especially in any given year, for the pursuit of investing mastery or even just enjoyment.
- You want a chance at the best possible returns in a given year, even if it means you significantly underperform.
When passive investing is better for you:
- You want good returns over time and are willing to give up the chance for the best returns in any given year.
- You want to beat most investors, even the pros, over time.
- You like and are comfortable investing in index funds.
- You don’t want to spend a lot of time investing, if you’re purchasing index funds.
- You want to minimize taxes in any given year.
Of course, it’s possible to use both of these approaches in a single portfolio. For example, you could have, say, 90 percent of your portfolio in a buy-and-hold approach with index funds, while the remainder could be invested in a few stocks that you actively trade. You get most of the advantages of the passive approach with some stimulation from the active approach. You’ll end up spending more time actively investing, but you won’t have to spend that much more time.
The easy way to make passive investing work for you
One of the most popular indexes is the Standard & Poor’s 500, a collection of hundreds of America’s top companies. Other well-known indexes include the Dow Jones Industrial Average and the Nasdaq 100. Hundreds of other indexes exist, and each industry and sub-industry has an index comprised of the stocks in it. An index fund – either as an exchange-traded fund or a mutual fund – can be a quick way to buy the industry.
Exchange-traded funds are a great option for investors looking to take advantage of passive investing. The best have super-low expense ratios, the fees that investors pay for the management of the fund. And this is a hidden key to their outperformance.
ETFs are typically looking to match the performance of a specific stock index, rather than beat it. That means that the fund simply mechanically replicates the holdings of the index, whatever they are. So the fund companies don’t pay for expensive analysts and portfolio managers.
What does that mean for you? Some of the cheapest funds charge you less than $10 a year for every $10,000 you have invested in the ETF. That’s incredibly cheap for the benefits of an index fund, including diversification, which can increase your return while reducing your risk.
In contrast, mutual funds are typically more active investors. The fund company pays managers and analysts big money to try to beat the market. That results in high expense ratios, though the fees have been on a long-term downtrend for at least the last couple decades.
However, not all mutual funds are actively traded, and the cheapest use passive investing. These funds are cost-competitive with ETFs, if not cheaper in quite a few cases. In fact, Fidelity Investments offers four mutual funds that charge you zero management fees.
So passive investing also performs better because it’s simply cheaper for investors.
Passive investing can be a huge winner for investors: Not only does it offer lower costs, but it also performs better than most active investors, especially over time. You may already be making passive investments through an employer-sponsored retirement plan such as a 401(k). If you’re not, it’s one of the easiest ways to get started and enjoy the benefits of passive investing.