Everyone has very different risk tolerance levels, so it’s important to understand your own preferences and investing goals before you choose between active and passive investing strategies.
Active vs. Passive Investing Definitions
Actively managed investments, such as mutual funds, try to beat the market performance of a benchmark index, like the S&P 500, by choosing the best 100 or so performing stocks. The best performing stocks are chosen based on the likelihood of receiving a good return.
A passively managed investment will simply accept that market performance is what it is and invest in all 500 stocks on the index.
Which is Better – Active or Passive?
Many investors wonder what the better option is for their own investing goals. Once again, it does come down to the individual investor’s personal levels of risk tolerance.
The level of risk you’re willing to take with your hard-earned money can often determine how you’re willing to spend and invest. After all, higher risks can often yield higher returns. Unfortunately higher risks can also compound losses too.
Low risk might equate to lower returns, but it’s commonly believed that a low guaranteed gain is far better than a risky bet on a higher risk return that you may never cash out on.
Active Investing
An active investor understands that not all stock prices move at the same rate or even in the same direction as the entire market as a whole. They will actively try to single out individual stocks that have the likelihood of out-performing the index.
In most cases, actively managed mutual funds carry higher costs. This is partly associated with the higher trading costs, time costs involved with researching likely stock picks and management costs. Simply put, more work is put in, the costs increase as the effort increases.
For those investors who wish to take on their active investing activities themselves rather than trust their money to a fund manager, then day trading on the stock market is a very similar tactic. You spend the time researching stocks that are likely to outperform the index and you manage your portfolio personally, buying and selling as you try to capture profits and minimize losses. Don't allow this approach to intimidate you, as nobody should or will care about your money more than you do.
Passive Investing
A passive investor will understand that as the market index moves up or down, then having a passively managed fund that is broadly diversified across almost all the available stocks on that index is likely to return average returns that are somewhat in line with the returns shown by that index.
Passively managed funds often carry lower fees and may tend to offer lower returns. However, those lower returns are often favored by investors who believe that receiving a low return is better than risking the chance of receiving no return at all. I tend to agree. Its more of a slow and steady wins the race, long term type of approach.
For investors who once again don’t wish to trust their money to a fund manager, then your passive investing option is to develop a broadly diversified stock portfolio that you hold for the long term. You have the choice of allowing your stocks to simply sit in your portfolio and collecting the dividend or you can reinvest your dividend earnings back into your portfolio to buy more stocks.
