Passive vs. Active Investing: Which is Best for Who?

Why don’t more people use a passive investment strategy when it seems clearly superior to active investing? This intriguing question was asked by a follower. While there are many who would disagree with the premise that passive investing is superior. I’m not one of them. Let's explore further. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Passive Investing

Passive investing is, generally speaking, a long-term, hands-off investment strategy as opposed to active investing, which often involves making regular trades in an effort to achieve short-term gains that “beat the market.” Like myself, passive investors usually invest in:

• Index (and/or exchange-traded) funds that track benchmarks;

• Target-date funds that consist of stock and bond index funds that are periodically rebalanced as one approaches retirement; and,

• Other quality mutual funds that an investor purchases on a simple dollar-cost averaging basis.

Passive investing focuses on funds versus individual stocks.This appeals to me for two primary reasons.

1. First, a buy and hold strategy creates fewer taxable events, whether they be capital gains OR losses.

2. Second, because index funds are “unmanaged” and, by definition, stock trades are vastly reduced, investment costs and fees are significantly lower than in active trading.

Conservative investors like me prefer to create a passive portfolio and let the market take over. That’s not to say that we completely ignore certain market activities…like personally rebalancing our non-target date funds…but our involvement in the marketplace usually amounts to an occasional check of how things are going – and most certainly does NOT involve joining the thundering herd during those discomfiting market corrections.

Limitations of Passive Investing

A passive approach to investing can limit an investor’s choices since the basics of many index funds are similar – although ETFs have broadened that scope. And, because passive investing, broadly speaking, simply keeps pace with a given market rate of return, the passive investor foregoes the opportunity to beat the market. Recall, however, that most “unmanaged” funds outperform “managed” funds over the long term (primarily due to those lower fees and tax efficiencies).

Time in the market rather than timing the market is the essence of passive investing.

Active Investing

Active investing involves a more studied, hands-on approach to investing. Whether it be you or your money manager, someone has to constantly monitor the market and its incessant fluctuations – seeking those profit opportunities that occasionally present themselves. It largely involves the pursuit of short term gains…a pursuit that necessarily involves considerable time and laborious research.

By definition, active investors usually have a mindset that enables them to quickly adjust their portfolios as opportunities arise versus the buy and hold crowd. This mindset opens the door to considering various investment techniques, which probably includes risky endeavors like market timing and short selling. Still, that same flexibility offers the possibility of uncovering big winners and the opportunity to outperform the overall market. And, isn’t that what active trading is all about?

The Cost of Active Investing

According to the S&P Dow Jones Indices:

• Over a five-year period 75% of actively managed funds fail to beat the market index

• Over a 10-year period 85% of actively managed funds fail to beat the market index

• Over a 15-year period 90% of actively managed funds fail to beat the market index

This is not a pretty picture considering that one must expose oneself to higher costs both in time and money. It makes me wonder why an investor would pay more for an actively managed fund that likely will underperform the less costly passive fund. Which raises the question: If you choose to be an active investor in individual stocks, will you, too, underperform the market?

Which is Best for You?

It’s difficult to say in absolute terms which strategy is best. Each approach might best serve the needs of a particular personality type; thus, neophyte investors must figure out which approach best suits them. If an individual is a hands-on type, seeking a low cost, tax efficient approach, and is at peace with the market rate of return year over year, then passive investing is probably the ticket. However, if an investor has the time and inclination to commit to a more personalized, short-term/higher risk experience, then active investing might be the better choice.

In Sum

Before a new investor jumps into active investing, he or she should take the time to learn the fundamentals of investing. In the absence of this basic understanding of the rigors of investing, in my opinion, it's simply best to take the passive approach until sufficient skills have been learned before embarking on an active strategy. And at the top of that learning curve is the determination of what an individual’s investment goals really are. The debate over which investment strategy is best…active or passive…will continue to be passionately discussed. One way or the other, that very personal decision should be reached after carefully comparing the pluses and minuses of one with the other. Good luck.