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You’ve taken the time to learn the ins and outs of investing, but how do you begin planning your overall investing strategy to secure your financial freedom? Like your investment options, you have options when it comes to putting your investing plans into action too. And depending on your unique goals, you may consider taking a leading role in your plans or even working with a wealth manager who can provide additional guidance. Knowing the difference between active vs. passive investing will help you understand and consider your strategy options. In this lesson, we cover the attributes of active vs. passive investing, the pros and cons of each, and much more.
What Is Active Investing?
Active investing involves a more direct, hands-on approach to buying and selling stocks. Typically, active investors enlist the assistance of a portfolio manager because this type of investing requires a significant amount of attention. People who actively manage investments are proactive and make money management decisions based on their analysis and findings before stocks rise or fall in the market. By buying or trading off stocks according to their careful decision-making and expertise, portfolio managers aim to beat the averages of the stock market and cash in on their strategic moves.
The key to actively investing requires much more than a gut feeling about a particular stock. Professionals use a series of calculations, usually supported through an investing team, to help guide their decisions. Then they purchase or sell the stocks that will hopefully be profitable. To benefit from an active investment approach, it’s key for investors to hit the mark to avoid making costly moves. Researching the best stocks to buy as well as keeping a close eye on the market is crucial for making informed decisions.
What Is Passive Investing?
Passive investing is simply matching the market’s returns by owning low-cost ETFs or mutual funds and allowing them to play out. With a passive approach, your investment decisions are likely driven by longevity rather than riskier, “big win” moves. With the single purchase of an ETF or similar fund, passive index investments offer a simpler approach rather than frequently buying or selling shares. Instead of trying to anticipate upcoming changes in the market, passive investors tend to give their investments time to mature and aim to match the performance of a major index such as the Dow Jones Industrial Average (DJIA) or S&P 500.
Over time, the gains from matching the market’s returns could add up to significant returns with minimal micro-managing required. And since this investment strategy requires much less active management or even the need for additional help, passive investing is typically less costly than active investing.
The Differences Between Active vs. Passive Investing
To help you make the best investment decisions to meet your goals, it’s important to understand the advantages and disadvantages of different investment strategies. Both approaches have their high points and drawbacks, and many investing pros are divided on which method is best. Now that you understand what each strategy generally involves, let’s compare active vs. passive investing and explore the main differences.
Pros of Active Investing
Taking a proactive stance with your investing decisions offers a variety of advantages including:
Chances of greater rewards
With active investing, your investments can benefit your finances significantly if you make wise choices. Unlike passive investing, your payoff is not limited to how a certain index performs. Ideally, when the market rises, active investors will see a larger profit from their efforts. And when the index falls, it won’t be as costly for the active players. Instead, their investment choices may increase gains with the market’s success and preserve their funds more so than others who lose with the market when it dips.
Active investors aren’t limited to the restraints of a certain market. Rather than being limited to buying or selling certain funds, investors are free to make buying or trading choices that are most beneficial for them. This flexibility presents investors or portfolio managers with the opportunity to pounce on stocks they predict will provide the most financial gains and forego those they believe may fall.
Unlike passive investing, active investors can diversify their portfolios in more ways than their counterparts. Proactive investors tend to flesh out their portfolio with a variety of investments beyond ETFs and mutual funds such as individual stocks, commodities, and more. With a diversified portfolio, investors may have additional strategies to help reach their financial goals.
Cons of Active Investing
While an active-oriented investing strategy can be beneficial, keep in mind the following drawbacks, too:
Chances of greater risks
The rewards can be greater, but so can the risks, with an active approach to investing. Of course, the goal is to beat the market and get returns on your investments, but actively investing may have risks if a poor investing decision is made. Buying into a crashing market or selling your shares before a surging market can impact your savings.
When comparing active vs. passive investing, active investing may be more costly. If you rely on a team to manage your money, those costs can add up. Typically, wealth managers charge a fee to oversee and handle your investments based on the value of the assets you hold. If you choose to actively invest on your own, you’ll need to pay brokerage fees each time you shift your money around the market.
Requires more time commitment
Actively investing requires an active role. Simply put, an active strategy can take more time, whether you enlist the help of a team or venture out solo. Keeping up with the ebbs and flows of the market is a constant job and staying vigilant may be more work than some investors desire.
Pros of Passive Investing
Managing your investment with a passive approach offers the following benefits:
Less chance of risk
With a “buy and hold” strategy, a passive investor has less risk to consider. Rather than attempting to outsmart a complex market, investments made by a passive strategist simply follow the market’s performance. There is less guesswork involved, and investors can rely more on the long-term growth of the market.
Unlike active investing, passive investing can be more budget-friendly for investors. After you purchase an ETF or mutual fund, there are no other brokerage fees to pay other than a low, ongoing fee. Plus, even if a passive investor hires additional outside management, those fees are generally lower since there is less work required of the wealth management team.
All investing requires some effort, but passive investing is typically less intense than active methods. Analyzing the market and keeping up with ever-evolving trends isn’t as necessary for a passive investment strategy to be successful. Instead, investors likely need to dedicate a small window of time spread throughout the year to ensure their decisions align with their goals. After a few working sessions, there’s minimal upkeep required to manage investments.
Cons of Passive Investing
Along with the pros of passive investing, keep the following cons in mind as well:
Decreased potential for rewards
Just as your risk with passive investing is lower, so is the potential for rewards. In general, passive investing is seen as safe, but that can mean you are less likely to hit a home run with your investments unless the stock market performs significantly well as a whole. On that same note, if the overall market dips, so will the return on your investments as they typically mimic the market.
Passive investors may have fewer alternatives when the market goes down. Just as you can ride market successes, you may be subjected to the pitfalls when things take a downward turn. You will be stuck with the funding choices you’ve made and simply need to ride the market out until it bounces back.
Active vs. Passive Investing: The Bottom Line
When faced with choosing an investing strategy, it's easy to become overwhelmed with your decision or feel you have limited options. And while both passive and active investing offer their own sets of advantages and disadvantages, there’s no one-size-fits-all approach to choosing a strategy.
Many investing pros are divided on which approach may have the best payoff, and some even recommend a combination of the two strategies. Whichever way you choose to invest your money, the best approach is to be as informed as possible on your financial decisions. Plus, our Profit Academy resources are always available to help you through the process every step of the way. From creating an investing strategy to brushing up on your investment knowledge, you’ll be one step closer to taking control of your financial freedom with our investment courses.