Active Investment Management or Passive Investment Management? That is THE question. Among investment professionals, anyway. While these two investment approaches can spark heated debate, few investors can effectively describe the difference. But understanding the difference between Active and Passive investing is consequential to your investment portfolio.
Active Investing Summarized
Let’s start with active investing. The main goal of active investing is beating the overall market by investing in securities deemed underpriced. Active managers analyze financial statements, sales figures, trading activity, corporate strategy and employ technology among many other strategies to determine which investments should make money. The expectation is that this underpriced investment will perform better than the overall market. But as with any good thing, there’s a downside. Active investing can sometimes get it wrong and while analysis may suggest that an investment will outperform the market, it could end up horribly underperforming.
Contrast active investing with passive investing. Passive investing is based upon an Index. An index is a way to measure how the prices of a basket of investments changes over time. The basket of investments typically represents a slice of the market that investors want to monitor.
Passive Investing Summarized
Let’s look a well-known index, the Dow Jones Industrial Average, one of the oldest indices that tracks 30 blue-chip US stocks that trade on the NY Stock Exchange and the NASDAQ electronic marketplace. The Dow index is priced based on the underlying constituents and then tracked over time to indicate how that slice of the market has performed. In this way, an index acts like a benchmark or standard indicator of how well or poorly a slice of the market has performed over a specific time period. An investor cannot invest directly in an index. It’s a theoretical measurement. That’s why index funds were created to replicate or approximate the performance of an index. In contrast with active investing, that tries to beat a particular market, passive investing based on the performance of an index, tries to mimic the market performance.
Active and Passive Investing Head-to-Head
So which investment strategy, Active or Passive, makes sense for you? Many investors don’t employ strictly one investment strategy over another, but it’s important to understand the opportunities and challenges of each.
With active investing, you have the flexibility to invest in what you want, when you want it. You can invest in what you believe in and avoid what you don’t.
Active investing has a higher level of speculative risk that could produce outsized gains but could bring the investor significant losses.
Active investing is typically more expensive than passive investing because it requires more resources to pay for data analysis and professionals to manage the investments.
And active investment performance has generally not beaten their market benchmarks over time due to increased competition, easy availability of information and high fees.
Now let’s look the main characteristics of passive investing.
While active investing is flexible, passive investments by design are structured and locked into the components of the index being tracked no matter what happens in the market and what you think of those investments.
For that reason, passive investments are transparent in that you can know what you’re buying by simply referring to the reference index. Many active investment funds do not reveal their investments to protect their proprietary research.
Passive investing is very low cost due to scalable operations.
And finally, passive investment performance has also held up over time due to lower risk and low cost.
The type of investment strategy you choose should be a combination of your financial means and goals as well as personal views.
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