Updated on Tuesday, November 24, 2020
When it comes to investing, there are two broad approaches: active vs. passive. An active investor is looking to buy and sell investments in order to earn a higher return than the market average. A passive investor does not make many trades and instead buys funds that try to match the average market return.
In this article, we look at the key differences between active vs. passive investing so you can decide which approach makes sense for you and your portfolio.
An active investor tries to earn an above-average return. They might measure their performance against a market benchmark such as the S&P 500, a listing of the stocks of 500 large publicly traded companies in the United States.
An active investor would research the 500 companies on this list, and other companies (for example, smaller or mid-size companies that would not be in the S&P 500) and try to buy the individual stocks they think have the best chance for high gains. They may also reevaluate their decisions regularly and sell investments they no longer think are good picks â€” or buy new investments that catch their interest.
Active investing is more hands-on and requires more research. Active investors may also use more high-risk, high-return trades, such as:
Active investors also may buy funds that are actively invested by money managers. Whatever approach they take, active investors are constantly looking for opportunities to make a profit.
Given the challenges and extra work involved, the approach is best for more sophisticated investors who want to be very involved in researching their portfolio.
With passive investing, you arenâ€™t trying to identify the best investments to beat the market. Instead, you invest your portfolio to match the return of a market benchmark, such as the S&P 500. There are index mutual funds and exchange-traded funds that track these benchmarks to deliver that return for your portfolio.
This takes much less work and the returns can still be quite reasonable. For example, from 1937 through 2019, the average annual return of the S&P 500 was around 10%. Of course, during a shorter period, you may get a return much lower â€” or higher â€” than that. You also have to keep in mind that past market performance is not necessarily indicative of future results.
With this approach, you also trade less frequently and arenâ€™t constantly replacing investments. Itâ€™s more of a buy and hold, long-term strategy.
Since youâ€™re making fewer trades with passive investing, you should owe less for investment fees. Passive investment managers also charge less than active managers. In addition, because you arenâ€™t selling your funds for a gain as often, you should minimize your capital gains taxes.
Passive investing is commonly used by less sophisticated investors as well as those who donâ€™t want to put in lots of work managing their portfolios. Itâ€™s a simpler way to earn a steady, long-term return.
One major difference between active vs. passive investing is that active investing has a much wider range of potential returns. If you make good investment picks, you could potentially see a much higher immediate return than with passive investing. On the other hand, if your picks turn out wrong, you could lose a lot more money. With passive investing, you earn the market average based on the benchmarks you pick. Thereâ€™s less upside but potentially less risk, making it a good choice for novice investors.
The active investing approach is also more expensive, due to the higher number of trades and capital gains, as well as fund fees. Passive investing allows you to minimize these taxes and fees. Finally, active investing takes more research and maintenance, as you keep an eye on market news. With passive investing, you donâ€™t have to put in this work, as you can basically just set your portfolio for the long-term and let it run itself.
|Active vs. Passive Investing|
|Active Investing||Passive Investing|
|Best for…||More experienced, hands-on investors who want to be very involved with managing their portfolios||Less experienced investors, as well as those who donâ€™t want to be highly involved with managing their portfolios (a set it and forget it attitude)|
|Investing approach||Frequent buying and selling investments in the short-term in an attempt earn high profits||A long-term, buy-and-hold approach that looks to earn the market average while minimizing taxes and fees|
|Fees||Higher, especially if you make frequent trades||Low|
|Average rate of return||Depends on your investment picks â€” can be above or below the market average, depending on your performance||The market benchmark average|
|Tax efficiency||Less efficient, especially if you make investments that last less than a year and owe short-term capital gains||More efficient due to a buy-and-hold strategy|
For most nonprofessional investors, passive investing is the safer choice. The fees are lower, itâ€™s easier and thereâ€™s typically less risk, as you consistently earn the average market return. If youâ€™re an experienced investor and passionate about following market news, active investing could be worth considering.
Active investing may be more appealing if you have some specialized knowledge that gives you an investing edge. For example, you may be a scientist or doctor who understands the research behind pharmaceutical stocks. While active investing does have higher fees and greater potential risk, if your picks work out, you could potentially earn a higher return.
Your portfolio could also be a combination of both approaches. For example, you might invest your long-term retirement savings using a passive approach while keeping some funds in a brokerage account for active trading. That way, you give yourself the chance for some short-term profits. If your trades donâ€™t work out, your passive investments could still reach your long-term goals.