Active Versus Passive Investing

There are two main approaches to investing: active and passive. While both strategies aim to grow wealth, they take very different paths to achieve that goal. Understanding how each works is key to deciding which method best suits your needs.

Let's break it down.

What Is Active Investing?

Active investing is all about hands-on management. It could involve an investor picking individual stocks or a team of analysts who study the market, make predictions, and adjust the composition of a mutual fund based on current trends or economic conditions. The goal is to "beat" the market, meaning to earn more than a standard benchmark, like the S&P 500 (an index of 500 large stocks).

This approach often involves market timing - buying and selling stocks frequently. Think of it like being on the field during a sports game. Active investors constantly adjust plays, reacting to what's happening in real time.

But with all that activity comes a cost. Actively managed funds usually charge higher fees because you pay for expertise and effort. And, despite the hard work, there's no guarantee that an active fund will outperform the market.

One of the big challenges active investors face is the difficulty of accurately predicting the market's movements. The stock market is influenced by many factors - economic data, corporate earnings, global events, and investor sentiment. Trying to predict these shifts in advance is tough, and even seasoned professionals don't always get it right.

What Is Passive Investing?

On the flip side, passive investing is more of a "set it and forget it" strategy. The goal here isn't to outperform the market - it's to match it. Instead of trying to pick winning stocks, passive investors often buy into index funds or exchange-traded funds (ETFs) that track a specific market index, like the S&P 500, Nasdaq, or the Dow Jones Industrial Average. This approach yields a naturally diversified basket of stocks across many different industries.

These funds aren't actively managed, which means they have lower fees. There's also less buying and selling, so you're not constantly triggering capital gains taxes. It's like putting your money on cruise control, letting it grow steadily over time without much interference.

While you won't beat the market with passive investing, you're less likely to lag behind it either. It's a long-term strategy designed to handle market ups and downs without too much emotional or financial stress.

The Cost Difference

When it comes to popular investing options like mutual and exchange-traded funds, one of the most significant differences between active and passive investing is cost. Actively managed funds tend to charge higher fees because of the research and management involved. You're paying for the expertise of a portfolio manager who's making decisions for you. There are also tax implications of frequent buying and selling, which will impact the overall results as well. Over time, these costs can eat into your returns.

Passive funds, by comparison, are much cheaper. Because they're simply tracking an index, they require less day-to-day management and there are fewer taxable events to impact overall cost. Lower fees mean more of your money stays invested and can grow over time.

Here's an example: let's say you invest $100,000 over 30 years. Say an actively managed fund charges an expense ratio of 1%, while a low-cost index fund charges just 0.1%. Both funds achieve an average annual return of 7% before fees.

Here's how your investment would grow in each scenario:

• Actively Managed Fund - With a 1% fee, your net return is 6% per year. After 30 years, your $100,000 investment would grow to about $574,349.

• Index Fund - With a 0.1% fee, your net return is 6.9% per year. After 30 years, your $100,000 investment would grow to about $761,226.

That's a difference of nearly $187,000 simply because the index fund has lower fees. Over time, even a slight difference in fees can significantly impact the overall growth of your investment.

What Does "Winning" Look Like in Investing?

In investing, the idea of "winning" can mean different things depending on your strategy. For some, winning means trying to outperform the market, aiming for returns that exceed standard benchmarks like the S&P 500. This is the goal of active investing - making strategic moves, timing the market, and picking stocks that are expected to deliver outsized gains.

But here's the catch: consistently beating the market is incredibly hard. Even professional fund managers, with all their experience and resources, struggle to do it year after year. In fact, studies show that the vast majority of actively managed funds underperform the market over the long term. According to the 2023 SPIVA U.S. Scorecard, only 7% of actively managed funds managed to beat the overall market over the past 15 years or so.

On the other hand, matching the market through passive investing can also be considered a win. By simply tracking an index, you benefit from the market's overall growth without having to predict its movements. You avoid the risks of picking the wrong stocks or mistiming trades. For many investors, this steady, lower-cost approach leads to solid returns over time, with less stress and fewer fees.

Remember, past performance isn't a guarantee of future results. So maybe, over the next 15 years, more actively managed funds will somehow consistently beat the overall market. But here's the key question: Is it worth chasing those elusive extra gains, or is it smarter to stick with the broader market's natural growth?

Which Approach Fits Your Style?

Choosing between active and passive investing really comes down to your personal goals and how much time you want to spend managing your investments.

If you like the idea of staying on top of market trends, analyzing companies, and potentially beating the market, active investing might be more your speed. Just keep in mind that even with a team of experts on your side, there's still a risk you won't get the returns you're hoping for.

On the other hand, passive investing could be the way to go if you prefer a lower-cost, low-maintenance option that grows with the market. You won't see the thrill of trying to beat the market, but you also won't face the heartache when a big bet doesn't pan out.

You also don't have to choose one or the other. Many investors use a mix of both strategies. You could put part of your money in actively managed funds or even buy and sell individual stocks yourself. Meanwhile, you could invest the rest in passive funds, letting that portion of your money march the market's overall growth over time.

This blended strategy may give you the best of both worlds: the chance to chase higher returns on one side while keeping things steady on the other.

The Bottom Line

There's no one-size-fits-all answer to choosing between active and passive investing. It depends on how much risk you're comfortable with, how much time you're willing to invest, and how much you're okay with paying in fees.

Active investing might sound appealing because it offers the potential for higher returns, but it comes with higher costs and more inherent risk. Passive investing isn't about beating the market but matching it with the lowest possible fees, so more of your money stays invested over time.

In the end, whether you go active, passive, or use a mix of both, the important thing is that your strategy fits your long-term goals. If you have questions about your investing approach, please discuss your situation with a qualified professional.