Active investing vs. passive investing: What’s the difference?

Passive investing can be a huge winner for investors, and not only does it offer lower costs but it also performs better than most active investors.

Active investing may sound like it’s a better approach than passive investing. After all, we’re prone to see active things as more powerful, dynamic, and capable. Active and passive investing each have some positives and negatives, but the vast majority of investors are going to be best served by taking advantage of passive investing through an index fund.

Here’s why passive investing trumps active investing and one hidden factor that keeps passive investors winning.

What is active investing?

Active investing is what you often see in films and TV shows. It involves an analyst or trader identifying an undervalued stock, purchasing it, and riding it to wealth. It’s true – there’s a lot of glamour in finding the undervalued needles in a haystack of stocks. But it involves analysis and insight, knowledge of the market, and much work, especially if you’re a short-term trader.

Advantages of active investing

Disadvantages of active investing

What is passive investing?

In contrast, passive investing is all about taking a long-term buy-and-hold approach, typically by buying an index fund. Passive investing using an index fund avoids the analysis of individual stocks and trading in and out of the market. The goal of these passive investors is to get the index’s return, rather than trying to outpace the index.

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Advantages of passive investing

Disadvantages of passive investing

Active investing vs. passive investing: Which strategy should you choose?

The trading strategy that will likely work better for you depends a lot on how much time you want to devote to investing, and frankly, whether you want the best odds of success over time.

When active investing is better for you:

When passive investing is better for you:

Of course, it’s possible to use both of these approaches in a single portfolio. For example, you could have, say, 90 percent of your portfolio in a buy-and-hold approach with index funds, while the remainder could be invested in a few stocks that you actively trade. You get most of the advantages of the passive approach with some stimulation from the active approach. You’ll end up spending more time actively investing, but you won’t have to spend that much more time.

The easy way to make passive investing work for you

One of the most popular indexes is the Standard & Poor’s 500, a collection of hundreds of America’s top companies. Other well-known indexes include the Dow Jones Industrial Average and the Nasdaq 100. Hundreds of other indexes exist, and each industry and sub-industry has an index comprised of the stocks in it. An index fund – either as an exchange-traded fund or a mutual fund – can be a quick way to buy the industry.

Exchange-traded funds are a great option for investors looking to take advantage of passive investing. The best have super-low expense ratios, the fees that investors pay for the management of the fund. And this is a hidden key to their outperformance.

ETFs are typically looking to match the performance of a specific stock index, rather than beat it. That means that the fund simply mechanically replicates the holdings of the index, whatever they are. So the fund companies don’t pay for expensive analysts and portfolio managers.

What does that mean for you? Some of the cheapest funds charge you less than $10 a year for every $10,000 you have invested in the ETF. That’s incredibly cheap for the benefits of an index fund, including diversification, which can increase your return while reducing your risk.

In contrast, mutual funds are typically more active investors. The fund company pays managers and analysts big money to try to beat the market. That results in high expense ratios, though the fees have been on a long-term downtrend for at least the last couple of decades.

However, not all mutual funds are actively traded, and the cheapest use passive investing. These funds are cost-competitive with ETFs, if not cheaper in quite a few cases. Fidelity Investments offers four mutual funds that charge you zero management fees.

So passive investing also performs better because it’s simply cheaper for investors.

Summary

Passive investing can be a huge winner for investors: Not only does it offer lower costs, but it also performs better than most active investors, especially over time. You may already be making passive investments through an employer-sponsored retirement plan such as a 401(k). If you’re not, it’s one of the easiest ways to get started and enjoy the benefits of passive investing.

Last updated on August 11, 2022, and last reviewed by an expert on July 14, 2022.
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