Active investing vs. passive investing: What’s the difference?
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. But in investing, active loses out most of the time to passive and it’s not really even close.
Here’s why passive investing trumps active and one hidden factor that keeps passive investors winning.
What are active investing and passive investing?
Active investing and passive investing are two broad approaches to earning returns.
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 glamor 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.
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.
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 have an index comprised of the stocks in it. An index fund can be a quick way to buy the industry.
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.
Pros and cons of active investing
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.
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. 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.
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.
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 2018 report from S&P Dow Jones Indices shows that more than 63 percent of fund managers investing in large companies underperformed their benchmark in the prior 12 months. And it gets worse over time, with more than 92 percent unable to beat the market over 15 years. These are professionals whose sole focus is to beat the market by as much as possible.
But that feat is tremendously difficult to achieve. That’s where passive investing comes in.
Pros and cons of passive investing
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.
Plus, 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. Buy-and-hold investors can defer capital gains taxes until they sell, so they don’t ring up much of any tax bill in any given year.
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 that’s another advantage of passive investing – the free time to do whatever you want, instead of worrying about investing.
Of course, 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.
The easy way to make passive investing work for you
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 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.
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