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How does passive and active investing differ?
If you’re looking for ways to grow your money, you may have heard of the term ‘investing’. Investing refers to the process of buying assets that are likely to increase in value over time to provide returns.
Passive and active investing are two different styles of investing, and both have their pros and cons. In general, passive investment is considered less time-consuming, while active investing often requires a more hands-on approach.
What is a passive investing strategy?
Passive investing can be understood as an investment strategy for the long term. Passive investors don’t trade assets regularly to beat the market. Instead, they buy and hold assets for long periods to generate positive returns.
Passive investing is based on the assumption that the market tends to give positive returns over a medium to long period of time, say five years or more. As markets are cyclic in nature, they tend to go up and down, due to various economic factors. However, the market tends to correct itself over time, and investors who continue holding on to their assets during low periods may end up benefitting during the correction.
Passive investing is usually favoured by individuals with a low-risk appetite and those who’d like to take a set-and-forget approach. It involves investing in assets that track a market index, or a specific market segment.
Index funds are a typical example of the passive funding approach. An index fund is an investment fund that mimics a popular index, say the ASX 200. When you buy into an index fund, you get exposure to all the company shares included in that index. So, if you buy into an ASX 200 fund, you’ll gain exposure to all the 200 companies listed on that index – potentially leading to a well-diversified portfolio.
As the fund mimics an index, the fund manager doesn’t have to decide which shares to buy or sell, resulting in lower management fees. Passive investing could thus be considered a more affordable way to access the market, and it can also help reduce investment risk through portfolio diversification.
What is an active investing strategy?
Active investing generally refers to trading in line with market trends. Active investors follow a more hands-on approach, buying and selling assets frequently to make profits.
Unlike passive investors, active investors don’t hold stock for the long term. Instead, they try to take advantage of short-term price fluctuations in the market for capital gains. The aim of an active investor is to beat the market, for which they must actively observe the market and follow trades.
As this is a time-consuming activity, some active investors prefer to engage professional fund managers to invest on their behalf. Investing in active Exchange Traded Funds (or ETFs) is also possible if you wish to try active investing but don’t have much time to trade actively.
An ETF is a basket of shares, managed by a fund manager, which can be bought or sold on an exchange, like the ASX. While more ETFs are index traded funds, you may also find some active ETFs, where a fund manager actively manages a portfolio of securities. However, it’s important to research the securities or stocks in the portfolio and keep track of their performance as long as you stay invested.
Keep in mind that there is no type of investing that is risk-free. That being said, active investing is often considered riskier than passive investing, as active investors try to predict the market in the short-term, which cannot always be done accurately. Additionally, active investing might cost you more than passive investing in terms of transaction fees (owing to constant buying and selling) and portfolio management charges if you're investing through a manager or fund.
Passive vs active investing: how do the two investing strategies differ?
Passive investing | Active investing |
May be suitable for long-term investors who want to invest in the market but don’t want to get involved in hands-on trading. | May be suitable for investors who wish to make short-term profits by observing the market trends and acting on them. |
Beginners might find it easier to invest in passive funds that track an index instead of actively trading stocks for profit. | Not ideal for beginners that don’t understand the various tools and charts that traders use to time the market. You can seek help from a fund manager to manage your portfolio but it helps to understand the basics when you want to trade actively. |
Generally considered a cheaper investment strategy compared to active investing due to lesser trades and low involvement of fund managers. | Active investing may be more expensive due to the fees incurred on trades. The portfolio management fee is also likely to be higher for active funds, due to the active involvement of fund managers. |
Passive investment funds mimic the composition of an index and tend to benefit from passive diversification, and may be less likely to underperform. You may expect the same return and risk as the market average when you invest in passive funds. | The returns from an actively managed portfolio may not be benchmarked against an index. The risk and returns depend on the market movement, but you may try to reduce your risk by investing in diverse stocks. As the aim of an active fund is to beat the market, you might expect above-average returns, but your investment could also tank if the market doesn’t move as you expected. |
Should you choose a passive or active investing strategy?
Choosing between passive and active investing styles comes down to your personal preferences and investment goals. If you want to invest over the long term and you're looking for a less risky investment strategy, you might want to consider passive investing by purchasing index funds or ETFs. However, passive funds don't aim to beat the market; they simply track the market, which means the returns could be smaller.
Active funds, on the other hand, are considered suitable for investors looking to make short-term gains. As an active investor, you must have a high-risk appetite, because you're essentially trying to outperform the market by guessing how a certain stock will perform. Depending on your research and luck, you might earn higher than average profits, or you could even lose your money if the market doesn't perform as you expected.
It's also possible to have a mix of active and passive funds in your portfolio to try and benefit from both investing strategies. Investing in passive funds helps reduce the risk of underperformance. However, it also eliminates the potential for higher-than-average returns. If you're willing to take some market risk, you could consider investing a small part of your money in well-researched active funds to potentially improve your returns from your portfolio.
Irrespective of the strategy you choose, it is important to understand that no investment is free of risk. It is advisable to restrict your investments to an amount you can afford to lose to limit your market risk.
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