When you consider investing, then you will often read that there are two paths you could take. One is active investing, where you actively pick and buy stocks, and try to sell them at a higher price. On the other hand, you have passive investing, where you invest to try to match the performance of the market, which is often done via index funds.
In this article, we want to shed some light on the debate between active investing vs. passive investing, what each method is and which one would work best for you. We’ll also discuss ways to combine both strategies to perhaps get the best of both worlds.
What is passive investing?
With passive investing, investors try to earn the same returns that the market as a whole is producing. How to achieve and measure this? In the world of finance, a plethora of indexes exist that list the performance of certain sectors or the market as a whole.
One is the MSCI World, a global stock index that tracks the price performance of around 1600 stocks from 23 developed countries. However, you can’t just invest in an index. That’s why there are index funds like the iShares Core MSCI World UCITS ETF USD (Acc) – what a mouthful – that replicate the composition of this index, in which you can then invest.
Opposed to active investing, there is no active stock picking going on where hedge fund managers try to find the next Facebook or Tesla. It’s mostly automated and hence brings fewer fees with it.
So passive investing is a rather boring, yet effective way of putting your money to work: Since 1900 the S&P 500 – one of the world’s most well-known stock indices – has returned an average of 6.60% annual return after inflation.
Advantages of passive investing
Here are some advantages that passive investing brings with it:
- You can invest into the performance of the market or a sector as a whole
- Lower fees than active investing or active investment products
- No need to worry about constantly buying or selling
Disadvantages of passive investing
Every coin has two sides, so here are some downsides of passive investing:
- Returns of moonshots with 1000%+ will be evened out by the rest of the stocks in your portfolio
- A boring investment with not much to talk about with your friends
- Long-term average returns are often in the one-digit percent range, not higher
What is active investing?
If we classified both topics as subjects in school, then passive investing would be science and active investing art. While the former wholly relies on data to make decisions, the latter surely gets influenced by it, but ultimately decides on gut feeling.
With active investing, you or the fund managers actively pick the stocks which make it into the portfolio, in an effort to achieve higher than average (i.e. market) returns. But as nobody knows the future for certain, this often turns out to be not successful, with 80% of active fund managers falling behind major indexes.
Active investing often turns out to be difficult because as outlined in one of our previous articles, you only need to miss the best days of each decade, to eradicate your returns. Nevertheless, some active investors continuously make the right call and can therefore achieve average two-digit returns.
Advantages of active investing
Some advantages of active investing to keep in mind:
- You could make high returns
- It’s a more exciting way of investing because more things are happening
- More flexibility in volatile market (e.g. sell positions and hold cash, or invest into bonds etc.)
Disadvantages of active investing
Let’s look at some of the disadvantages of active investing:
- Higher fees than passive investing
- Increased risk to make lower returns than indexes
- Prone to investing into “trends”
Which investing strategy is better for you?
There’s no one-size-fits-all approach to investing. In the end it comes down to your preference, risk tolerance (check out our fun test), experience, reason behind investing and much more. So, you need to keep all these factors in mind.
Here’s an overview of when either the one or the other approach might be more fitting for you:
Choose passive investment strategy if:
You’re an inexperienced investor
You want to go the rather safe, but boring route
Your risk tolerance is low
Solid average returns are more important to you than achieving the best possible returns in one year
You aim to minimize the time you spend on investing
Choose active investment strategy if:
You like researching about companies, and spend time investing
The potential of outperforming the market and thousands of investors excites you
You don’t mind having a bad year
You’re an experienced investor who knows how to assess and hedge risk
Combining Active & Passive Investing
Active and passive investing don’t have to be exclusive, it’s not a club where you’re prohibited from entering if you enjoy the atmosphere in another establishment more. In fact, they make a great team.
For example, if you’re more inclined to invest passively, but you’re itching to also try picking some stocks, why not go 90/10? You invest 90% into index funds, but the other 10% you can use to play with and pick stocks that you think are interesting and/or will outperform the market.
That way, you also save yourself from eternally not listening to your feelings and all of a sudden, making a huge bet with money you can’t afford to lose – and lose it. Instead, you get the safety of knowing that the majority of your investment mirrors the market, while you still get the chance to be actively involved in your investment.
Conclusion
Active investing vs. passive investing is an age-old debate. Both sides have their pros and cons, but if you value certainty and low fees over flashiness and high fees, then passive investing is your choice. If you’re more drawn to making high returns and don’t mind if you lose out, then perhaps give active investing a shot.
Either way, they are both suitable to be combined as well. Just make a plan of how much safety and how much risk you want, and divide your portfolio depending on your answers. And surely, you’ll also find a spot for P2P investments in there!