Active investing sounds like what might happen if you called a stock broker between tennis sets. Passive investing seems like it might involve sitting on the sofa and shrugging a lot at your investment choices. Neither are accurate. Active and passive investing are in fact two distinct investing strategies, neither of which require the investor to do much of anything at all after choosing one.
The difference between active and passive investing
If you know anything at all about mutual funds, you probably already have a decent sense of what active investing is. The vast majority of mutual funds are actively managed, meaning they employ a fund manager, who’s a little like the captain of a ship or the CEO of a corporation. Before beginning a fund, the fund manager will set out his qualifications and general parameters for choosing securities in a prospectus, then, for as long as he’s the fund manager, will have a free hand to buy and sell securities for that fund in hopes of outperforming its benchmark, or the average return of similar investments. The mutual fund will grow and shrink according to how much is invested but its holdings will remain proportional to whatever the fund manager has set out. This buying and selling action is what makes this kind of investment active. You might say active investing involves a lot of futzing.
There’s little if any futzing with a passive investing strategy. A passive investor generally takes a position that doesn’t seek to outperform a benchmark, but rather exactly mirror it. A passive investor would, for example, seek to track the performance of the entire stock market. They could do this by investing in a single exchange traded fund — a single investment that allows you to invest in multiple companies (or bonds and real estate, too). They could decide to invest in the S&P 500, a fund that tracks the 500 largest U.S. companies. Or they might decide to invest in the smaller companies that make up the S&P 600. Generally, passive investors believe that regardless of how much their investments rise and fall in the short run, they'll probably grow over time. Passive investing can be achieved in a couple of ways, through index mutual funds, exchange traded funds (ETFs), or by investing your money with a robo-advisor. Both of these maintain their holding with little to no intervention of humans. Instead, computer algorithms will track whatever index or market the funds or ETFs are based on. So, for example, the composite of an S&P 500 ETF would look like a miniature version of the S&P 500, with all the stock weightings identical.
An active strategy operates on the idea that smart humans will be able to outsmart the markets — and indeed some have done so brilliantly. The most famous fund manager of all time might be Peter Lynch, the silver-haired stock savant who managed Fidelity’s Magellan Fund between 1977 and 1990, a period during which he averaged a staggering 29.2% return for investors. Other fund managers have not been as lucky and failed to outperform the market. Passive investors, on the other hand, are betting that over the long term, they will benefit from both the long established upward trajectory of markets along with the fact that passive investments’ management expense ratios, or MERs, are but a fraction of their active brethren. (Fund managers and their staffs aren't cheap, and investors pay their salaries and expenses.) Active management fees are typically in the neighbourhood of 1%, whereas the normal range of index ETF fees is between 0.05% and 0.25%. The fees that robo-advisors charge come somewhere in the middle with many charging in the region of 0.50%. Passive traders like to point out the numbers shared by academics and Vanguard founder’s Jack Bogle showing that fees are inversely predictive of returns, that is, the higher the fees, the lower the returns.
Criteria | Active Investing | Passive Investing |
|---|---|---|
| Goal | Beat the market (performance may or may not outpace the index) | Track the market (performance is generally in line with the index) |
| Diversification | Lower amount of diversification as it involves stock picking | High level of diversification as your investments are spread across many stocks and potentially bonds and real estate too |
| Cost | Generally more expensive as people are employed to pick stocks | Often cheaper as much of the work can be automated and fewer people are required |
| Account Minimums | Often a high barrier to entry in the form of large account minimums | Automated investing has removed the barriers to entry and you have the option to start with as little as $1 |
| Tax Benefits | There may be fewer tax benefits as you're trading more often | Investment providers with tax loss harvesting can reduce your tax bill by selling off underperforming assets |
| Control | Typically seen to have a high level of control | Less control as you track the entire market. The rise of socially responsible portfolios and Halal portfolios provide passive investors with some control over where they invest. |
Warren Buffett, who became one of the richest men in the world by picking specific companies and stocks to invest in, has spent the last decades discouraging pretty much everyone not named Warren Buffet from trying to make money through active investing.
Buffet favors passive investing and has long publicly encouraged his heirs to invest the lion’s share of their inheritance in low-fee, highly diversified stock funds when he dies.
Pros and cons of active and passive investing
Let's get one thing straight. Investing passively or actively in index mutual funds and/or ETFs is a far superior strategy to picking individual stocks because you're engaging in something called — diversification. Everybody has a friend whose uncle who knows a guy who invested $700 dollars in Amazon in 1997 and now owns his own continent. Less heralded but more prevalent are the tales of other guys who went all in on Groupon and had to move back into their parents’ garage! Picking stocks is only a marginally better idea than investing in lottery tickets. Many smart investors understand that one way to help protect against precipitous losses in specific stocks, specific economic sectors, and even specific country’s economies is through diversification. When you diversify your investments, if one goes sour it doesn't drag down your entire portfolio.
There's probably nothing that achieves diversification more than investing your money with a robo-advisor. They generally invest your money in multiple ETFs and mutual funds that allow you to invest in a combination of stocks, bonds, and real estate — to spread your money across multiple industries and markets. Many robo-advisors will also rebalance your portfolio so that you never need to worry about having too much money in any one investment.
The advantage of active investing is that sometimes, you might do really, really well. Had you owned the small cap Perkins Discovery Fund (PDFDX) in 2017, you would have enjoyed a 39.51% percent return on your investment. If you’d been invested passively in Vanguard’s 500 Index Fund (VFINX) during the same period, you’d only have experienced returns of 18.5%, less than half of the actively traded fund. But this creates a somewhat deceptive picture. Over a 10-year period from November 2008 to November 2018, the index fund actually outperformed the actively managed fund by more than 6%. This reflects a truism that passive investment devotees never tire of pointing out. While many active funds outperform passive funds in the short term, they will fail to outperform them in the long term. Studies have shown over and over again that the over 80% of actively managed funds by and large fail to outperform passive investments over the long term.
Active managers could argue that between 2008 and 2018, overall stock market returns were so fantastic it’s not all that surprising the market would outperform any given fund. It’s in bear (or down) markets when the active managers will really earn their keep, by preventing even steeper declines. But at least one study showed that this is but another investing myth. Thanks to the attention that passive investing has gotten, thanks in large part to the proselytizing of Vanguard’s Bogle, there’s been a seismic shift of money moving into passive rather than active investing. Along with this shift has emerged a small but vocal contingent of financial minds arguing that this massive outflow from active has created huge opportunities for active investors, and also created potential danger of steeper-than-ever witnessed market falls as a result of so much automated investing. Google “peak passive” or “passive bubble” to get a sampling of the Chicken Littles out there, and if you need some reassurance afterwards, read a study that pretty convincingly provides the historical goods on why passive wins.
Of course, the truth is, nobody can ever really predict what the future holds in the market. Investments are speculative and past results should never be understood to be guarantees, but instead imperfect predictors of future performance. So understand whenever you invest in the stock market, there's a chance you could lose a portion — or even your entire investment.
Active portfolio management vs. passive portfolio management
Whichever way you choose to go — active, or passive, or a combination of the two — you have the option to either invest it alone or with some help. You might be confident in being able to construct a good, solid, balanced portfolio yourself and choose to purchase your own ETFs by making trades. On the other hand, you might realize you don't have the time or knowledge to do it yourself and sign up with a robo-advisor who will invest your money based on your circumstances. Whatever investing strategy you decide on, try not to make changes along the way that are driven by your emotions. There’s probably never been a worse investing strategy than trying to time the markets according to when you imagine stock prices are rising or falling.
If you’re not sure of the difference between a dividend and a derivative and you need some help investing, big respect for you for admitting your limitations. These are full-service firms or individuals who’d be happy to manage your money for you. Some are spectacular. A handful are so worthless that they’re now doing time in the hoosegow. Research is a must, and as the famous case of Bernie Madoff showed, word of mouth is not always the most reliable indicator of quality.
When it comes to choosing an investment provider, it's important to understand exactly what you're getting for your money. Are you going to be getting some financial advice and help with your questions along the way or will you be left in the dark? Will they include handy services like portfolio rebalancing to ensure your investments are never dragged off course? Will they offer you tax loss harvesting to save you money on taxes when your investments go sour? Do they allow you to invest according to your values?
Remember what we told you earlier, about how fees will eat away your gains like pigs let loose in a Golden Corral? Money managers will generally charge you a management fee that will likely eat up around 1% of your entire portfolio annually. If your manager is a fan of active investing and purchases a variety of mutual funds that carry their own MERs of around 1%, suddenly, you have to overcome a 2% loss every year in order to even break even. If you had the misfortune of walking into a certain big name bank until very recently and asking for investing help, you might have ended up paying a 1.6% management fee to be advised to buy the banks propriety mutual funds, which performed worse and came with higher fees than their competitors’. Don't be afraid to ask: what am I getting for the fees I'm paying?
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