Active vs Passive Investing: Key differences
Are you trying to decide whether to pursue active or passive investing? If so, you're not alone. Many investors struggle with this decision, as both approaches have their own unique set of benefits and drawbacks.
Active investing may offer the potential for higher returns, but it also carries a higher level of risk and requires a significant time commitment. Passive investing, on the other hand, can be less time-consuming and carries a lower level of risk, but may also result in lower returns.
In this blog, we'll take a deep dive into the differences between active and passive investing, including the key characteristics of each approach, the pros and cons of each, and how to determine which one may be right for you. By the end of this blog, you’ll have a better understanding of the key distinctions between active and passive investing, and you'll be well on your way to making more informed investment decisions.
What is Active Investing?
Active investing is an investment strategy involving the frequent buying and selling of stocks with the aim to make short-term profits. Its main objective is to outperform a benchmark index and capitalise on price fluctuations.
Investors use active investment strategies when they want to clock returns higher than an index fund. Therefore, active investment managers check stock prices frequently.
Such an investment strategy may include purchasing inexpensive stocks or short-selling overpriced securities. Moreover, active management modifies risk and generates less volatility than the benchmark.
Active investors identify every investment’s entrance and exit points using a well-calculated and quantified strategy. They consider multiple measures to assess a stock before making an investing decision.
Moreover, active investment is extremely volatile (and risky) because the stock market fluctuates frequently. This is why a vast majority of active investors are unable to outperform passively managed funds on a consistent basis. Furthermore, active management funds demand higher fees than passive management funds.
Advantages & Disadvantages of Active Investing
Active investment has several benefits, including
Active investing can be used by a skilled financial consultant or portfolio manager to make trades to offset profits for tax purposes. This is known as tax-loss harvesting. Although tax-loss harvesting can be used with passive investing as well, the volume of trading that occurs with active investment techniques may generate more possibilities and make it simpler to evade high taxes.
Active investors can buy stocks that the market as a whole might not value or value as much as they should. They can quickly sell off stocks that aren't doing well if the risks are getting too high. Or they may decide not to invest at certain times and wait for good times to buy.
Alongside the advantages, here are some disadvantages of active investing to help you make a better decision:
Requires High Engagement:
Active investors must maintain market and investment-specific knowledge. This can be daily work, but active investors want to take advantage of significant market movements.
Most brokerages no longer charge trading fees for buying stocks and ETFs in a normal way. But there may be fees for more complex trading strategies that use derivatives. And if you put your money into funds that are actively managed, you'll have to pay high fees. Actively managed funds have generally high expense ratios due to the amount of research and trading needed.
Demands Higher Risk Tolerance:
Active investment can generate rapid growth if executed properly. However, with increased potential comes increased risk. Since active investment depends on short-term fluctuations, it is inherently more volatile.
What is Passive Investing?
As the name implies, passive investment involves the investor playing a passive role in the investment in that they do not watch the markets daily like active investors do. When you invest in a diverse portfolio with minimal costs and a long time horizon, you can expect returns that are similar to the market average.
Furthermore, passive investment is based on the assumption that the market will provide favorable long-term returns, hence the portfolio must be held without considerable changes for an extended period.
Passive investing involves buying and holding stocks for the long-term. Instead of attempting to outperform the indexes, they invest in funds that mimic their performance, evaluate, and try to match their pace.
Index and Exchange Traded Funds (ETFs) are the most effective passive investments. Such assets seek to replicate indexes such as the Sensex and Nifty50. This is the optimal method for those with long-term aims rather than regular stock trading rewards.
Advantages And Disadvantages of Passive Investing
Some key benefits of trading in passive investments are:
Passive investing yields exactly what it promises. In fact, the index that your fund follows is frequently part of its name, and it will never invest other than its titular index. On the other hand, actively managed funds may not necessarily provide this degree of transparency, and much is left to the manager. Additionally, certain strategies may even be hidden from the public in order to maintain a competitive advantage.
Low Transaction Charges:
Passive investment is associated with smaller trading volumes, which might result in cheaper expenses for individual investors. Furthermore, passively managed funds have lower expense ratios than active funds since they require less research and maintenance. In 2020, the average expense ratio for passive ETFs was 0.18%, whereas that for passive mutual funds was 0.06%.
Here are some of the disadvantages associated with passive investments:
Lack of Flexibility:
Passive funds are restricted to a certain index or fixed set of investments with little to no variation; hence, investors are locked into those holdings regardless of market conditions.
Passive funds almost never outperform the market, including during times of volatility, because their main assets are designed to mimic the market. In rare cases, a passive fund may outperform the market, but even then it will never achieve the large returns that active managers seek until the market itself bursts.
No Exit Strategy:
Passive investing does not have an exit strategy during severe market recessions because it is designed for the long term. While the market has traditionally recovered from every slump, there is no guarantee that it will do so quickly. This is one of the reasons why it is critical to constantly review your investment portfolio over time.
If you don’t have the time to examine active funds and you don’t have a financial counsellor, passive funds may be your best option. At least you won’t lag behind the market, and you won’t have to pay exorbitant expense costs. And for investors willing to be at least moderately involved in their investments, passive funds represent a low-cost option to gain exposure to specific sectors or regions without having to conduct extensive research on active funds or individual stocks.
But you don’t necessarily have to choose only one option. Some investors have constructed diverse portfolios by mixing well-understood active funds with passive funds that invest in unfamiliar markets.
Q. Is active investing better than passive?
This depends on the circumstances. In certain market conditions, investors have benefited more from active methods, while passive strategies have performed better in others. For instance, when the market is unpredictable or the economy is faltering, aggressive managers may outperform more frequently.
Q. Are ETFs passive or active?
ETFs can be managed either passively or actively. Actively managed ETFs aim to outperform a benchmark, while passively managed ETFs aim to closely follow a benchmark.
Q. Are mutual funds passive or active?
Mutual funds may be managed either actively or passively. Mutual funds that are actively managed typically have a designated portfolio manager, group, or organization. On the other hand, passive mutual fund managers constantly track the performance of a specific industry index or benchmark.
Risk is measured by the possibility of a decline in value and underperformance relative to expectations. In the blog, we will tell you all about investments that are high-risk and those that are low-risk.