January 22, 2024

By Daniel Masuda Lehrman, CFP®, CSLP®

Key Takeaways:

1. Active investing means being very involved in managing your investments, usually by a manager or someone actively engaged in it.

2. Passive investing requires less activity—investors often buy indexed or mutual funds and hold onto them.

3. In the past few decades, passive investments tended to make more money compared to active ones.

What Is Active Investing?

Active investing is like being really involved in managing your investments. It's all about trying to do better than what the stock market usually does. Whether it's a person managing their own money or someone doing it professionally, they're the ones calling the shots. They aim to take advantage of how prices for things like stocks, bonds, or other assets change in the short term.

This approach involves a lot of digging into information and making decisions based on that. There's usually a manager or a team of people who look at both the numbers and the qualities of a company or investment. They have specific rules they follow to decide when it's time to buy or sell something.

Active investing is not just about looking at how prices change; it also means understanding the basics of a company, like their financial statements. That way, investors can figure out if a company is doing well or not so they can make smart choices.

Benefits of active investing:

  • Potential for outperformance:  Active investing has the potential to outperform the market.  Active managers can use different methods, like short sales or put options, to protect themselves if things go bad. They can also leave certain stocks or industries if they seem too risky.This is a double-edged sword though, as it’s equally possible to underperform the market.  
  • Freedom: Active managers don't have to stick to a set list of stocks. They can invest in what they believe are great finds, even if they're not in popular indexes
  • Taxes: Although this might lead to a tax on profits, advisors can help manage taxes for each investor. For instance, they might sell investments that lost money to balance out the taxes on the ones that made big profits.

Downsides of Active Investing:

  • Costly: Active investing is more expensive. On average, actively managed funds have higher fees, around 0.68% compared to passive funds with fees at 0.06%. These costs add up due to frequent buying and selling, covering transaction expenses and the salaries of analysts. Over time, these fees can eat into your investment returns.
  • More Chance for Mistakes: Active managers have the freedom to pick any investment they like, but this can mean taking bigger risks.
  • Human Errors: Fund managers can make mistakes while investing because they're human. These errors could be expensive in the long run.

What Is Passive Investing?

If you're a passive investor, you aim for the long run and don't do a lot of buying and selling. It's a budget-friendly way to invest. Instead of reacting to changes in the stock market, you pick stocks or funds and hang on to them for the long term.

For example, buying an index fund that follows a big index like the S&P 500 or Dow Jones is a passive approach. When these indices change, the index funds automatically adjust what they hold. So, if a company joins one of these major indices, it becomes a key part of lots of significant funds.

When you own bits of thousands of shares, your profits come from the overall growth of corporate profits over time in the stock market. Successful passive investors focus on the long-term gain and don't worry too much about short-term drops in the market.

Benefits of passive investing

  • Super-low fees: Since no one's picking stocks actively, it costs way less to manage. These funds just track a chosen index.
  • Easy to see: You always know what assets are in an index fund.
  • Tax-friendly: Their way of buying and holding usually means you won't face a big capital gains tax each year.

Downsides of Passive Investing

  • Limited choices: These funds stick to a fixed group of investments or a specific index. You're stuck with those, no matter what's happening in the market.
  • No opportunity for outperformance: Passive funds usually won't outperform the market. Even if they do a bit better sometimes, they won't make the big gains that active managers aim for unless the market itself does really well.
  • Dependence on others: Passive investors don't get to choose where their money goes; they rely on fund managers to make those decisions.

Should You Choose Active or Passive?

So, which method helps investors make more money? You might think professional money managers could do better than basic index funds. But surprisingly, that's not the case. Studies over many years consistently show that passive investing tends to work better for most people.

Active mutual fund managers, both in the U.S. and globally, often perform worse than the index they're supposed to beat. For example, research by S&P Global discovered that over a 20-year span ending in 2022, only around 4.1% of managed portfolios in the U.S. consistently outperformed their benchmarks. Only a small number of actively managed funds do better than passive index funds.

However, saying passive is always better might be too simple. Both active and passive strategies have their place. While passive funds are more popular because they have lower fees, some investors are okay with paying higher fees for the expertise of an active manager, especially during unpredictable market swings.

About Daniel Masuda Lehrman

I am a Fee-Only Fiduciary and Founder of Masuda Lehrman Wealth LLC. Prior to starting my own firm, I was a Vice President Financial Consultant at Charles Schwab in their Downtown Honolulu office. I have worked in financial planning for 10 years at Vanguard, Fidelity, and Schwab. I'm a CERTIFIED FINANCIAL PLANNER™ professional (CFP®) and Certified Student Loan Professional with an Economics degree from the University of Michigan.

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