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Passive vs. Active Investing

Published April 23, 2021

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Financial Planning
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Investing can be confusing. Even to the professionals. One idea that can be confusing is the difference between passive and active investing–what is it?

Simply put, passive investing is when you minimize your investment activity by buying and holding your investments for a long period of time. Ideally, you’ll regularly add to your investment portfolio, regardless of what the market is doing. A popular investment choice for passive investors is to buy an index like the S&P 500 via a mutual fund or ETF.

Active investing is when investors buy and sell securities based on what they believe they’re worth. They believe the market will recognize the value they see, and the securities will appreciate (or depreciate) in value accordingly. They may hold onto their investments for a short, or a long period, but they have to monitor them closely for changes in price and respond to those changes. Hence, the “active” part of “active investing.” Typical investments for active investors include individual stocks and bonds.

What are the pros and cons of each approach?

Active Investing

Active investing is challenging, potentially rewarding, and involves significant risk. Many of us know someone who bought a stock when it was “cheap” and is now priced somewhere in the stratosphere. The problem is that this is much harder to do than it seems. It’s possible to find undervalued or misunderstood stocks, bonds and other investments, but it often takes a lot of work and a little luck. Also, keep in mind that while most people are happy to tell you about their winners, they usually fail to tell you about their losers. And in most cases, they probably have many more losers than winners. It’s very easy to lose money with active investing.

Pros

Flexible

You can buy whatever you want. This leaves with you many options. You can create a custom portfolio that reflects your risk tolerance and goals. You can also sell whatever you don’t want anymore.

Hedging

You can use options and other securities to hedge your exposures to certain stocks or sectors.

Tax Management

You can use capital losses you’ve incurred from your investments to offset gains in other investments to lower your taxes.

Cons

Risky

It’s difficult to find a good investment at a reasonable price. There’s a huge amount of competition and it’s very hard to get a competitive edge. You might pay too much for something. Competitors arise and can take away business. Companies lose money and go bankrupt. Any number of things can go wrong. The truth is in the numbers: the vast majority of active investment managers—professionals who do this for a living—don’t even match, let alone beat, their benchmarks.[1]

Fees

There are a lot of fees that come with active investing. If you manage your investments yourself, you’ll pay trading fees, mutual fund sales fees, and face tax liabilities. You’ll encounter these with passive investing as well but given the greater activity usually involved with active investing, your fees will likely be more than if you adopted a passive approach.

Where fees really start to add up is if you allocate money to an active investment manager, someone who invests your money on your behalf. That’s when advisor fees, sales commissions, and more will be added to your bill. Many of these fees may not be obvious, such as mutual fund load fees, but they can add up quickly and seriously affect your performance over a long period of time. Losing 1% of your performance to fees over 30 years can cost you thousands of dollars. For example, if you invested $100,000 and received a 7% return over 30 years, you would wind up with $761,225.50. If you had had recorded an 8% return, you’d end up with $1,006,265.69. The 1% difference adds up to nearly a quarter of a million dollars! And all in, annual fees can easily add up to well over 1%, meaning it’s easy to forego even more money. Small numbers can become big ones over a long period of time. Before you hire an active investment manager, be aware of exactly what fees you’ll be charged.

Time

Active investments require you to keep an eye on them. They may go up (or down) and you may want to adjust your exposure accordingly. Regardless, you’ll have to spend some time keeping tabs on how your investments are performing.

Taxes

As an active investor, you’ll hold your investments for varying periods of time, which will affect how any gains you might realize when you sell them, are treated. For example, gains from shorter term investments, like those held for less than a year, are treated as ordinary income, whereas gains from investments held longer than a year, are treated as long term capital gains and taxed at a lower rate. Active investors are more likely to sell investments after holding them less than a year and will thus be taxed at a higher rate than passive investors who typically hold investments for more than a year. One way for active investors to limit potential tax liabilities is by using a qualified account such as a 401k or IRA, which shields you from tax liabilities until you make withdrawals.

Passive Investing

Passive investing is considerably easier than active investing. Once you come up with a financial plan, it’s a simple matter to execute and monitor it. And for once, the easy approach is actually the better one for most people. With a little research and the right funds it’s cheaper fee-wise, and in the long term should provide good returns with lower risk than an active approach. Let’s see why.

Pros

Low cost

Passive investments are usually low fee investments—and we saw above how fees can impact your returns. A typical passive investment, like a best-in class index fund or ETF, has among the lowest fees of any investments you’ll encounter, with many index funds charging less than 0.1% annually.

Low risk

Passive investments, like index funds, expose you to market risk and nothing more. An active investment will expose you to market risk at a minimum, plus whatever additional risk that’s specific to your investment. Think of market risk as table stakes, or the price of admission. Markets rise and markets fall, and all investors have to be prepared for either eventuality, but over the long term, the stock market has provided good returns over a long period. For example, the average annualized return of the S&P 500 between 1926 and 2020 was over 10%.[2] Keep in mind that this is the average, which means that there were years where returns were much higher than this, as well as years where returns were much lower than this. If you invest funds into your passive investments regularly, you should earn good returns over the long term.

Discipline & consistency

If you come up with a financial plan that incorporates consistent additions to passive investments, and stick with it, you’ll avoid making spontaneous, emotional decisions. Decisions based on emotional reactions are often poor ones, especially when it comes to investments. If you can take emotion out of the equation, you’re more than halfway to becoming a successful investor.

Tax efficiency

As noted above, passive investments are usually held for longer than a year and are thus taxed at a lower rate as long term capital gains. If you don’t sell any of your long-term investments until after you’re retired, you’ll also likely be in a lower tax bracket as well.

Cons

Limited returns

There aren’t many drawbacks to passive investing. One of them is that you’ll be limited to whatever the returns are of your investment. So, if you’ve invested in an S&P 500 index fund, you’ll never get a return higher than the S&P 500 (or market) return. Thus, you won’t be able to brag that you bought the latest fad stock that quadrupled this year. That being said, remember that the majority of professional, active investors don’t even match the market return.

In summary

There are pros and cons to both active and passive investing. But for the vast majority of investors, a passive investment approach is probably the best choice. It’s cheap. It’s easy. It’s lower risk. And over the long-term, you’re more likely to enjoy higher returns than if you pursued an active approach.

 

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[1] 79% of large-cap institutional accounts and 82% of large-cap mutual fund managers underperformed the S&P 500® on a gross-of-fees basis over the past 10 years.  https://www.spglobal.com/spdji/en/spiva/article/institutional-spiva-scorecard/

[2] http://www.moneychimp.com/features/market_cagr.htm

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