The debate between active vs. passive investing is often framed within the context of which is better. But advocating one approach over the other isn’t necessarily helpful for new investors. Instead, what is often most helpful to these investors is a discussion that helps them understand the differences between each approach, as well as when and how it makes sense to utilize them in a portfolio.
Once you’ve established the right asset allocation mix for your risk tolerance, time horizon, and investment needs and goals, the next step is implementation — choosing your investments.
When selecting investments for your portfolio, one of the first decisions you’ll make as an investor is deciding between active vs. passive investment strategies. Understanding the potential advantages and disadvantages of both investing styles, as well as the importance of having a diversified portfolio, can help you determine whether to deploy an active or passive investment approach, and when to do so.
Here are some of the key differences between active and passive investing strategies:
Active investing
The goal of active investing is to “beat the market,” or outperform a given benchmark. Active investment decisions are often based on rigorous research and analysis of an asset. Other factors that can influence an active investor’s decision to buy or sell a particular investment include market trends, the economy and political climate.
Unlike an index fund, which is designed to mirror the composition and returns of an index, an actively managed mutual fund will seek to generate returns that are different than those of the benchmark.
Advantages of active investing:
Flexibility: With active investing, portfolio managers and investors aren’t required to hold certain stocks and bonds, which means they not only have a wider opportunity set to select from, but they can also benefit from short-term trading opportunities.
Risk management: Unlike passive strategies, which ebb and flow with a market, active investors can manage their exposure to risk by avoiding or selling certain holdings and market segments. In addition, some active managers can use short sales, put options and other strategies to hedge against risk.
Tax management: Actively managed strategies can be tailored to particular investor needs, such as tax efficiency. For example, an actively managed portfolio can harvest tax losses by selling underperforming investments to offset the capital gains tax on outperforming ones.
Actively managed portfolios generally have higher fees than passive portfolios. This is because you’re paying for the expertise of a professional money manager to pick investments and monitor your portfolio.
However, even small fees can chip away at returns and have a big impact on performance. This makes it harder for actively managed funds to consistently outperform their benchmarks: It isn’t enough for an active manager to just beat the index; the fund must also outperform by a margin that is wide enough to cover the expenses.
A major difference between active vs. passive investing is that, with active strategies, investors have a wider range of potential returns. As an active investor, if you make good investment choices, you could potentially see a much higher return than you would with a passive investment. On the other hand, if your investments perform poorly, you could also lose more money.
Active management can really shine in times of volatility and in certain niche markets, such as emerging market and small-company stocks, where information is limited and assets are illiquid.
Passive investing
The goal of passive investing is to match the performance of an index or benchmark, rather than outperform it. Passive investing is more of a buy-and-hold approach with limited turnover, which keeps costs low.
One of the most common ways to invest passively is to buy index funds, which are designed to track the performance of a particular index. Passive managers simply seek to own all of the underlying assets in a given market index, proportionate to the index.
Passive strategies have grown in popularity over the last few years as research shows that a passive benchmarked strategy can deliver solid returns, but with lower fees and less effort than an actively managed approach.
Advantages of passive investing:
Low fees: Fees are generally lower for passively managed funds because there is less overhead. Nobody is actively picking investments, and there is no need to analyze benchmark holdings.
Transparency: Investors typically know which stocks or bonds are held in an indexed investment.
Tax efficiency: Most index funds do not trigger a large annual capital gains tax because they do not trade often.
However, one of the main drawbacks of passively managed portfolios is that you have less control over your investments, because you’re usually investing in a predetermined selection of securities. This means you won’t be able to make adjustments if certain sectors or companies become too risky or are underperforming.
With passive investing, you earn whatever the market earns, based on the benchmark you pick. This means you participate fully in a market upturn, but you also fully participate in the losses when the market declines.
Passive strategies are generally recommended if you have a lengthier time horizon or are in a situation where you want to minimize fees.
Neither active nor passive investment strategies are mutually exclusive, so you may have a combination of each in your total portfolio.
This article originally appeared on Forbes.
