What is active investing?
Active investing (sometimes referred to as ‘active money management’) is a term that refers to portfolio management strategies where an investment advisor or mutual fund manager makes researched investment decisions that are designed to outperform a benchmark index (like the S&P 500 or Nasdaq). This is generally done using micro and macroeconomic analysis of an asset’s fundamental features but those using short-term strategies might even rely on technical chart analysis to make forecasts for where market prices are heading next. The goal of an active investor is to generate higher returns by focusing on specific assets, rather than buying the market in its entirety.
These strategies generally require the ongoing buying and selling of a variety of assets on a near-continuous basis. Market positions can be undertaken in any asset class (ETFs, stocks, bonds, currencies, commodities, etc), but active investors must continuously monitor their market positions in order to find and exploit profitable opportunities as they arise.
Active investing is rigorous process and involves a high level of market participation. Where passive investors might invest in a stock based on its long-term potential for appreciation, active investors might instead focus on short-term price movements on a daily, hourly, or even minute-by-minute basis. This type of strategy is best for those looking to capture short-term profits.
What is passive investing?
In passive investing, money managers are looking for profit gains that more closely mirror the returns and investment weighting seen in a benchmark index. Because of this, passive money managers will typically use index funds as the main vehicle for investment. Passive investment strategies involve more limited buying and selling activity that require less maintenance, with investment positions designed to capitalize on prospects for long-term capital appreciation. For these reasons, passive investors are much more interested in the “buy-and-hold” approach that is less vulnerable to daily fluctuations in volatile short-term environments. Success in passive investing requires solid research in the early stages, portfolio allocation that is well-diversified, and the patience to allow markets to move in their favor.
Unlike active investors, those using passive strategies will typically buy a security without the intention of profiting from short-term changes in the market. Passive investors will instead base their decisions on the underlying economic fundamentals and the prospects for long-term growth in the asset. This is also where the importance of diversification comes in, as broader exposure to different market assets will help shield against uncertainties in any one sector. Think of it as betting on most of the horses in a race, rather than the single “long-shot” that could produce bigger gains but also generates more risk.
Which approach is better?
For those with a more conservative approach (and less tolerance for risk), passive funds tend to be the best option. Some advantages of these funds can be seen in their lower fees (since the positions require less maintenance) and reduced capital gains distributions to file on your tax return. But the true benefits extend far beyond the lower fees and taxes. The stark reality is that most active managers fail to beat the market on a consistent basis. So, while you might see advertised examples of money managers that have had one or two good investment years in a row, their performance numbers tend to drop when looking at things from a longer term perspective. Another element to consider is the fact that actively-managed portfolio strategies tend to fluctuate between profits and losses at a much more volatile (and unpredictable) rate. This can create financial difficulties — especially for those close to retirement. For these reasons, the stable, safe, and preferable approach lies in passive investment practices.