Should You Be an Active or Passive Investor?
One of the age-old debates in the investment world is whether an active or a passive approach is superior. The multi-billion-dollar investment advisory industry makes the argument that active management is the better option — because their livelihood depends on it. On the other side of the coin, index and exchange-traded fund companies argue the opposite, and for the same reason.
But as an individual investor, what is really the best choice for you? While the answer varies from investor to investor, there are some obvious pros and cons to each approach that can help you make your own personal decision.
Definitions of Active and Passive Investing
Active investing involves researching and trading individual equities or other investments on a regular basis, moving in and out of positions based on trends and analysis.
Passive investing involves holding a basket of stocks, typically a market index like the S&P 500, and simply earning the return of that underlying investment.
Pros of Active Investing
The primary benefit of active investing is that it offers the potential to beat the return of the overall stock market. In fact, that’s the primary objective.
By analyzing stocks and the market as a whole, a knowledgeable active investor — or a hired, professional money manager — can move in and out of positions, sectors and industries to both get ahead of the next major trend and to avoid any coming downdrafts.
A secondary pro of active investing is that it gives investors the feeling of control. By making every buy and sell decision of every single security — or even handing that over to an active manager — an investor can feel like they are truly in command of their own ship, rather than passively tracking an index.
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Cons of Active Investing
The major con of active investing is that it takes time and knowledge to be successful. You can’t be a winning active investor without doing your homework. If you’re a fundamental investor, this means digging through company earnings reports, industry-wide research documents and doing your own analysis of economic and monetary factors. If you’re a technical investor, your research will include analyzing chart patterns and understanding which trends are likely to remain in force.
Another con of active investing is that it typically costs more. While you may work with a zero-commission broker, you’ll still have to pay various trading fees. Even worse, your successful trades will most be of the short-term variety, meaning a higher capital gains tax rate. If you’re hiring a professional to actively manage your portfolio, this will obviously result in higher costs as well.
Pros of Passive Investing
Passive investing allows you to match the performance of an underlying index — often the S&P 500 — without having to make any investment decisions about specific stocks. You won’t have to comb through earnings reports from individual companies or worry about anything really except whether or not you want to be in the market.
Passive investing also tends to be low-cost. In most cases, you can buy or sell them for $0 commission, and index funds generally have extremely low expense ratios as well. While you can trade in and out of index funds and other passive investments, they’re generally designed for long-term investors, which can also reduce capital gains taxes.
Although results are constantly disputed by active investors, numerous studies have shown that passive investing often outperforms active investing. Part of the reason for this is that it’s hard to beat the market consistently over time. Even Warren Buffett himself, the billionaire chairman of Berkshire Hathaway known as the “Oracle of Omaha,” believes that for the average investor, low-cost index funds are usually the best way to go.
Cons of Passive Investing
When you commit to a passive investing strategy, you’re by definition agreeing to accept an “average” return. When you invest in an S&P 500 index fund, for example, you are destined to never outperform the market. While active investing can generate substandard returns, it allows for the possibility of outperformance.
For some investors, passive investing can also seem effortless and boring. While some advisors will suggest that “boring” is the key to long-term success, individual investors might feel like they’re just handing over the keys to their portfolio to someone else, and that might not sit well.
For the average investor, passive investing is likely the way to go. Not only does active investing require much more time and effort, but for the vast majority of traders, it’s actually more likely to end up in underperformance. This is typically due to either overtrading by an individual investor or the fees that drag down the total return of a professional money manager.
The exception to all of this, of course, is if you’re the rare active investor who can truly spot trends before they happen — with the discipline to avoid overtrading as well. In that case, active investing has the potential to provide outsized gains.
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