When diversifying your portfolio, you’ll run up against the age-old investment question. Which will yield higher returns, active or passive investing? While there’s a compelling argument for both options, the answer usually lies in the middle. Here’s a rundown of the differences between active and passive investment.
Active and passive investment: the basics
At heart, the difference between active and passive income investments boils down to how they are managed. As the name suggests, active investments require a more hands-on management approach. These funds are set up to outperform a benchmark index, with human analysts to watch trends carefully.
By contrast, passive investing is often more popular because it lets you buy index or mutual funds and then let the index itself do the heavy lifting. It takes a more long-term investment view with less active buying and selling, often earning more money in the long run. Yet at the same time, active investing is on the up and tends to become more attractive during times when the market is volatile. Both investment styles can yield benefits, and both can include a range of asset types and levels of risk. We’ll take a look at how they work in greater depth below.
Active money management aims to beat the index’s average, or benchmark returns. To achieve higher returns, a portfolio manager watches price fluctuations carefully to buy and sell as often as needed. This requires a high level of expertise and often involves a full team of analysts who can analyse the market to keep on top of all movements and act accordingly. If they can get it right, you can reap high rewards; but when the market behaves unpredictably it can all go wrong.
Here are the benefits of active investing:
Ability to hedge: Experienced active managers can use strategies like put options and short sales to mitigate risk.
Greater flexibility: Because active managers don’t have to follow any specific index, they can focus on the more left-field stocks that might hold potential.
On the other hand, active investing is far more expensive than passive investing. Because you have to pay a portfolio manager to actively buy and sell, you can expect to pay much higher fees. Buying and selling stocks also incurs repeated transaction costs. There’s also a higher risk involved, and the majority of active funds underperform the benchmark index.
Now let’s turn to the world of passive income investments. While active investing banks on the volatility of daily price fluctuations, passive investing looks at portfolio management from a long-term lens. The best passive income investments use a buy and hold strategy, resisting any sudden dips or climbs in the stock market’s prices.
One of the most common examples is to invest in an index fund that follows a major index like the Dow Jones Industrial Average. The fund follows the index closely, earning returns slowly over time. Buying and selling is limited, which cuts down significantly on transaction fees.
Benefits of passive investing include:
· Lower costs: In addition to reduced transaction fees, passive investing also means that you don’t have to pay a team of professionals to pore over your portfolio.
· Simplicity: Passive investing is often automated, with the fund simply tracking the index as a benchmark. There are no decisions to make.
While the best passive income investments are reliable slow burners, there’s a lack of excitement and returns will be more limited. Your fund will track a predetermined investment, without any variance.
Active vs. passive investing: how to choose
Now that we’ve outlined all the key differences between active vs. passive investing, how can you determine which is the best option? This depends on your investment goals, time frame, and comfort with risk. Looking at performance alone, passive investing almost always comes out on top in the end. Because its fees are so much lower, they don’t eat into the returns.
At the same time, when active investments do well, the returns make the risk worthwhile for some investors. This is particularly true during times of financial volatility, so it’s worth weighing all options with your financial manager for advice.
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