Active vs. Passive Investing: How to Choose an Investment Strategy for You

What we’ll cover:

• Whether or not you choose active vs. passive investing will depend on your savings goals and comfort level
• Passive investing is typically a less involved investing strategy and one that’s more focused on the long-term. Investors usually add money to their portfolios at regular intervals, whether the market is up or down
• Active investing is a more hands-on investment approach – the goal is to beat the stock market’s average returns by taking advantage of price fluctuations in the market
  

Do you like to be hands-on with your investments, where you’re on the field with the coaches, switching up the plays to try and earn the biggest return? Or do you prefer to watch the action unfold from the sidelines, putting money in steadily but not trying to beat the market? These strategies, called active and passive investing, respectively, are two investing approaches that could help you reach your money goals in different ways. 

Active investors buy and sell assets when they think it’s “the right time” to do so in an effort to outperform the market. Passive investors tend to take on more of a buy-and-hold approach, limiting the number of transactions they carry out, and typically try to match, rather than beat, the market. 

You may be wondering which approach might work for you. The answer is it depends on your savings goals and comfort level. 

Understanding the benefits and drawbacks of both strategies, as well as the importance of having a diversified portfolio, can help you decide which investment style to use and when. 

Ahead, we’ll compare active and passive investment strategies to see how each might suit your money goals and investing preferences. 

The difference between active vs. passive investing

What is passive investing?

Passive investing is typically a less involved investing strategy and one that’s more focused on the long-term. Passive investors aren’t constantly trading in an attempt to profit off of short-term market fluctuations. Instead, they usually add money to their portfolios at regular intervals, whether the market is up or down. Typically, passive investors believe it’s hard to beat the market, but if you leave your money in, over time you could get a solid return with lowers fees and less effort. Many robo-advisors essentially manage your portfolios, such as retirement accounts, based on your investment objectives. 

One of the most common ways to invest passively is to buy index funds – these are pre-selected collections of securities like stocks and bonds that are set up to track the performance of a particular index. Let’s say you purchase a passively-managed index fund that mimics the performance of the S&P 500 Index; if the S&P 500 gains 10% in a year, that index fund should, too. Keep in mind though, any fees associated with the fund will result in a lower gain.

What is active investing?

Active investing is a more hands-on investment approach. Someone – either a money manager or you, if you feel confident enough – watches the market and makes changes to a portfolio based on what they believe will bring the greatest potential returns given market conditions. Active investors usually do a lot of research, taking into consideration how market trends, the economy, and politics might impact the best time to buy or sell. While this may seem straightforward, even advanced portfolio managers typically can’t out-perform the markets. 

An example of a popular active investment product is a mutual fund, which can include stocks, bonds, and money market instruments. Unlike index funds, which track and watch index movements from the sidelines, a mutual fund is often managed by a money manager, who makes trades actively to determine the game’s progress. But remember, you can also manage mutual funds on your own.  

Pros and cons of passive investing

If you think passive investing sounds too, well, passive, know that being a spectator can have its merits. According to Morningstar, passive investing strategies for most investors can perform just as well, if not better, than active ones. 

In fact, only 23% of all active funds beat the average of their passive rivals over the 10-year period ending June 2019.

But, that's not the only benefit of a passive approach. Other reasons to consider this investing strategy are:

• Lower fees. Because there’s nobody actively picking stocks on your investments, passive investing may result in less overhead and therefore fewer and lower fees. 
• Tax efficiency. Since they’re usually not buying and selling on the regular, passive investors are typically not subject to large annual capital gains taxes, which are taxes on your profits from selling assets that you’ve had for more than a year.
• Transparency. By looking at your portfolio, you’ll be able to see exactly which assets are included in a fund. 

As with any form of investing, the passive strategy may have drawbacks. These include: 

• Less control over your portfolio. With a passive strategy, you’re usually buying into a set collection of securities, so you won’t be able to make adjustments if certain sectors or companies become too risky or are underperforming. 
• Potentially smaller short-term returns. Passive investments typically never outperform the market, so you might miss out on larger short-term gains that active investing could offer.

How to get started with an investment strategy  

While both passive and active investing strive to earn you the best returns, there’s debate about whether being hands on or off will get the job done more effectively. Which approach you choose will depend on your goals, timeline, and how confident you feel about you or a portfolio manager timing the market. And it’s important to know that the same types of funds can be managed in different ways. For example, you could have an actively managed mutual fund made up of the top 100 companies in the S&P 500 Index, or a passively managed mutual fund that includes all 500 stocks listed in the S&P 500.  

After evaluating both investing strategies, you can get started by going through an online broker or robo-advisor. You can also buy mutual funds, stocks, bonds, and other securities through investing websites and apps, or work with a financial advisor who can suggest a mix of assets for your money situation. 

Here are some general guidelines that may help point you in the right direction.

When to consider a passive investment approach: 

• You’re working with a long timeline. Retirement accounts or a child’s college fund (like a 529 plan), can historically yield good returns when they’re managed passively. It’s worth taking a look at the fine print and fees of your accounts to confirm how they are managed. For example, some target-date retirement funds – investment vehicles that rebalance the portfolio from more to less risk as you near retirement – may include actively managed mutual funds. You can typically tell by the fees – actively managed accounts tend to have higher ones.  
• You want to minimize fees. If you don’t want to spend a lot of money to invest but still want to see results, passive investing may be a good bet.
• You’re able to mentally commit to it. When you passively invest your money, especially over a long period of time, you’re most likely going to see a lot of ebbs and flows in the market. If you don’t feel the need to jump in and make moves with your money every time the market takes a dip, passive investing may work well for you. 

When to give active investing a shot: 

• You want to move with the market. If “set it and forget it” isn’t your style and you’d rather take regular action with your money, or you want a more personalized investing experience, then active investing may be a good option for you.
• You're looking for a short-term profit. If you want the chance to outperform the market in a shorter timeframe, you may want to take the risk that a money manager might be able to do that. A short-term goal might include raising funds for an event in the near future, like a major purchase or life event. Just remember, all investments come with risk, so if there's money you can't bear to lose, consider a savings vehicle, like a certificate of deposit. 
• You’re interested in investing in niche markets: When you or a money manager is tapped into emerging companies or sectors, you may be able to spot rare investing opportunities and act on them via active investing.

Yes, a mix of both passive and active investing is possible

With the stock market looking different every day and economists officially declaring that we entered a recession in February, getting a strong handle on what your investment strategy should look like right now is no easy feat. 

Remember, there’s no one-size-fits-all approach to investing – perhaps, you'll determine that a mix of both strategies could fit into your goals.

For example, maybe you want to leave your long-term goals, like retirement, to passive investments, but want to work with a money manager in the short term for something you know you’ll want returns for sooner than later, like a down payment for a vacation home. 

You can also take a more active approach to your passive investments by adjusting your investment objectives, a strategy called tactical asset allocation, and making sure elements like the stock-to-bond ratio to help potentially maximize returns and match your overall comfort level. This may help you feel some level of control when market conditions are volatile. 

The good news is that unlike sports where you’re either the coach or a spectator, with investing, you’re not confined to either active or passive strategies–you can get in on the action when you want to, sit out, or do a mix of both.