Financial Planning
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Not all investors use the same investing strategies. Your approach to investing may depend on your financial goals and level of expertise.
Individual investors, especially beginners, typically take the route of passive investing, which aims to match the returns of an index or overall market and steadily build wealth over the long term, often with low fees and relatively low risk.
In contrast, more advanced or risk-tolerant investors may prefer an active investing approach that tries to outperform the market, such as by capitalizing on short-term fluctuations or finding securities that beat average returns.
Here's a closer look at how passive investing and active investing compare.
Passive investing doesn't mean that you don't care about your investments — being passive is just a strategy that essentially says markets are efficient, and over the long term, it's hard to beat the average net of fees. So, instead of trying to pick stocks that beat the average S&P 500 returns, for example, passive investing might involve buying and holding an S&P 500 index fund that in the long run potentially outperforms those trying to pick and choose investments or time the market.
Passive investing (aka passive management) is a low-cost, long-term investing strategy aimed at matching and growing with the market, rather than trying to outperform it. With passive investing, you generally ignore the daily fluctuations of the stock market. Moreover, you hold funds or investments that aim to match the returns of an index — usually a broad-based one (or a few) that approximate the returns of the overall stock market.
You might still make some decisions, like choosing your weight of U.S. vs. international funds, but typically once you set those targets based on your goals and risk tolerance, you try to maintain those asset allocations in the belief that over the long run, your passive investments will outperform those who try to time the market or select investments that do not match index returns.
"At its heart, passive investing is a long-term investment approach where you buy a mix of stocks and bonds and other assets and hold onto them, regardless of market fluctuations," says Brent Weiss, CFP, cofounder, and head of financial wellness at Facet.
A buy-and-hold strategy is one of the most common and well-renowned passive investing techniques. Instead of trying to buy when prices seem low or sell when they seem high, a buy-and-hold strategy generally involves investing on a set schedule (like with payroll deductions going into your 401(k) every two weeks) or just investing in one lump sum.
That's because it's very difficult to know when the optimal time to buy or sell is. You might sell after a big run-up in the stock market, for example, but who's to say that prices won't climb further, causing you to miss out on more gains?
Instead, a buy-and-hold strategy requires you to keep a cool head and maintain an optimistic outlook. By holding on to the same investments over time, you're typically improving the likelihood of earning a greater return down the line compared with frequent trading.
Common passive investment vehicles
While technically it's possible to set up a passive investment strategy by buying and holding individual securities to match an index, typically this is achieved by buying investment funds. Typically, exchange-traded funds (ETFs) are passive investment vehicles, but not all are, so it's important to carefully consider the fund's strategy.
Also, among passive ETFs, there's a lot of variation in terms of what indexes they track. Some are broad-based, like those that track the S&P 500 or Russell 3000, while others are narrow, like only applying to a specific sector. So, while these narrow funds might technically be passively managed, they generally don't conform with the overall passive investment strategy of trying to match broad-based market returns (whether that's the stock market, bond market, etc.).
Another common passive investment vehicle is a mutual fund, though there are also a lot of active mutual funds, so it's important to understand what you're buying into. The main difference between ETFs and mutual funds is that ETFs are traded on stock exchanges and priced in real time, while mutual funds are managed off of exchanges by financial institutions and priced once per day after the market closes.
Sometimes for passive investing, a mutual fund makes more sense if you want to avoid the temptation to trade frequently, as ETFs are a little easier to get in and out of usually. However, mutual funds often have higher minimums, fees, and tax liabilities.
Note: Passive funds, whether ETFs or mutual funds, are often called index funds. You can't directly invest in an index, but these funds aim to match an index. Index funds typically have very low fees compared to active funds.
There are many potential benefits to passive investing, such as:
Diversification
Passively managed funds typically invest in hundreds to thousands of different stocks, bonds, and other assets across the market for easy diversification. You're generally less susceptible to the ups and downs of the market when diversified.
Sometimes, index funds focus on a certain area of the market, such as emerging markets, large caps, or technology companies, but you're still generally gaining exposure to many assets through one vehicle. Also, index funds are typically low-cost, so it's easy to diversify by holding multiple index funds to cover different areas of the market.
That's not to say that active funds are not diversified — many are — but if you're comparing passive investing through index funds vs. choosing your own individual stocks, for example, then passive investing provides the benefit of easy diversification.
Lower risk
As a product of diversification and the buy-and-hold, long-term approach that generally comes with passive investing, this strategy is often lower risk than active investing. Some active strategies are more focused on risk mitigation, but on a general level, passive funds are considered lower risk.
Lower fees
Index funds, such as passive ETFs or passively managed mutual funds, are generally affordable investment vehicles with lower management fees and reduced trading activity than most active funds. They incur fewer trading costs and taxable events, and the management fees usually reflect how they don't require nearly as much maintenance or research as active funds do.
"It's important to remember that when it comes to investing, it's not just how much you make but how much you keep that matters. Investing with low fees and paying less in taxes means more of your money is working for you," says Weiss.
Tax management
When you trade less, as passive funds generally do, you often benefit from a tax perspective — especially when funds are held in taxable accounts, like non-retirement brokerage accounts.
"Less buying and selling of investments means fewer taxable events like capital gains, and ultimately less taxes paid by investors along the way," says Weiss.
Beginner-friendly
Passive investors and beginners generally go hand in hand, as online brokerages often offer managed portfolio options with user-friendly interfaces that allocate investors' funds into a variety of passive funds that match their risk tolerance and goals.
Higher returns on average
This benefit might seem counterintuitive because the point of active funds is to try to outperform the market. However, many studies show that passive funds outperform active funds over the long term, particularly when accounting for fees. You might have some years where active investing does better, but it's very hard for active fund managers to consistently beat the index, especially when looking at five- or ten-year returns, if not longer.
Transparency
Passive funds tend to be transparent. Typically, you can tell what an index fund or ETF invests in simply through the name. For example, Vanguard S&P 500 ETF tracks the S&P 500 index, and the Fidelity ZERO Large Cap Index Fund tracks over 500 U.S. large-cap stocks. Many active funds are also transparent, such as to comply with mutual fund disclosure rules, but some active funds like hedge funds are not transparent.
While there are many potential benefits of passive investing, some possible downsides include:
Limited flexibility
Passive funds can be more limiting than actively managed funds. Because these track indexes, the fund manager generally can't adapt to changing market conditions. The only changes typically occur when the underlying index changes, such as when a company is added or removed from an index.
In a market downturn, for example, an active fund manager might retreat to lower-risk assets, while a passive fund would not adapt. However, this isn't always a negative, as it can position you to enjoy a market recovery.
Potentially lower returns
Although passive funds tend to have better returns net of fees on average, there's still the potential for underperformance compared to active funds. And in general, the ceiling is lower. An active fund might take on more risk for potentially higher rewards, like allocating a high percentage to a particular stock that's quickly rising.
In contrast to passive investing, active investing involves making investment decisions based on the investor's or fund manager's convictions, rather than following the index.
Active investing (aka active management) is an investing strategy often used by hands-on, experienced investors who trade frequently. Unlike passive investing, which aims to match the market, active management's goal is to outperform the market, often through a combination of picking investments that differ from the index, weighting assets differently than the index does, and trying to time investment decisions.
Some individuals engage in active management themselves by picking and choosing investments they think will beat the index, but in many cases, investors turn to professional portfolio managers who manage active funds.
Both mutual funds and ETFs can be actively managed, but it varies by fund. Also, many private funds, accessible only to high-net-worth investors, such as hedge funds, are actively managed.
Pros of active investing
Active funds can potentially provide advantages over passive funds, such as:
Increased flexibility and trading strategies
Active portfolio managers don't have to follow specific index funds or pre-set portfolios. Instead, active fund managers can pick and choose investments as they see fit and respond to real-time market conditions in order to try to beat benchmarks.
Also, rather than only utilizing the buy-and-hold philosophy to grow wealth in the long run, active investors can implement other trading strategies like shorting stock or hedging. Shorting stock is when an investor essentially bets on the price of the stock dropping. Hedging is a risk management strategy to protect investors against potential losses. That said, these strategies are often used by more specialized active funds, not all.
In general, passive investing is considered lower risk, but sometimes the flexibility means that active funds carry lower risk than passive index funds, such as if they engage in substantial hedging. Ultimately, it depends on the strategies.
If you're considering managing your investment portfolio yourself, make sure you are equipped with a meticulous level of financial knowledge and economic expertise. However, even experts struggle to beat the market over the long term, so don't assume you'll beat the market.
More tax-loss harvesting opportunities
Although active management often results in more taxable events, it's also possible that a portfolio manager engages in a specific strategy known as tax-loss harvesting to lower your tax liability. Tax-loss harvesting is when you sell securities, like stocks or ETFs, at a loss to offset capital gains elsewhere in your investment portfolio. While some robo-advisors or financial advisors offer this feature as a slight tweak to traditional passive strategies, active managers sometimes make it more of a focal point to try to improve net returns.
Potential for higher returns
With higher risk comes a higher chance of reward. Although there's often a greater chance that you'll lose your money by trying to outperform the market — and usually passive outperforms active in the long run — the rewards can be higher if you succeed. Similar to gambling, the chance of hitting it big may be enticing to some.
In contrast to some of these possible advantages to active investing, there are possible downsides, such as:
Lower long-term returns
Despite the potential to outperform the market, active tends to underperform passive when looking at long-term results.
"It's important to note that research shows that people and fund managers do beat the market from time to time. However, the vast majority of investors do not consistently beat the market over long periods of time," says Weiss. "In reality, any edge they may create is often eliminated by the additional fees they charge, the trading costs they incur, and the higher taxes they create."
Increased risk
Active investing often attempts to benefit from short-term price fluctuations by implementing trading strategies like short-selling and hedging. When active fund managers are successful, the returns can be great. But when they aren't successful, you could not only underperform passive but also lose significant money.
Higher fees
Active fund managers tend to charge higher fees since this strategy requires a higher frequency of trading and more specialized expertise. The difference might not look like much, with annual expense ratios for actively managed funds often ranging from around 0.5% to 1.00%, compared to passively managed expense ratio fees from around 0% to 0.5%. Still, over many years and as portfolio amounts grow, the higher fees of active can massively cut into returns.
More taxable events
Although some active managers engage in tax-loss harvesting to the benefit of investors, many active funds end up doing the opposite.
"Active investing creates more taxable events (e.g., capital gains) for investors, which means they will pay more in taxes along the way," says Weiss.
Passive and active investing are very different strategies. Some of the key differences include the following:
Cost and fees
In general, active investing costs more than passive due to factors such as higher fund management fees, trading fees, and taxable events. Also, active funds sometimes have higher investment minimums than passive funds.
Risk and return
The consideration of risk and return between active and passive can vary a lot based on the fund, but to generalize, active has a higher risk/return profile than passive typically. There's the potential for active to outperform the market and have very high returns, although there's often a higher risk of losses. More importantly, the risk of active is that in the long run, passive tends to have higher net returns. You might get lucky and outperform, but the odds generally aren't in your favor.
Time commitment
Passive tends to be more associated with buy-and-hold, long-term investing, although plenty of active investors are long-term investors too. Still, active is sometimes used as a short-term strategy, such as to try to take advantage of certain market conditions that someone thinks they can exploit.
Market efficiency
In general, passive investors believe that markets are efficient, meaning that prices accurately reflect fair values based on all available information, with risk/reward constantly priced in. For example, you might think that a new tech company's stock will soar in value, and thus become an active investor by buying a lot of shares to tilt your portfolio in that direction. Yet a passive investor generally believes that the tech company's stock price already reflects the potential for future growth, so you're not necessarily gaining an advantage by investing now.
In contrast, active investors often believe that there are informational inefficiencies that they can exploit. For example, a stock analyst at an active fund manager might hypothesize that other investors are not paying attention to a company's potential to expand into new markets, and thus the stock price could be undervalued. Thus, picking that stock, rather than just following the index, could lead to outperformance.
Neither theory is definitively right or wrong. It depends on what you believe. Also, many experts suggest that certain areas of the market, such as large-cap stocks, tend to be more efficient, while less-covered sectors may offer more opportunities for active investors.
Both passive and active investing strategies have their pros and cons. Picking the best strategy between passive or active investing depends on your circumstances and convictions. Some ways to approach the issue include:
Passive investing for long-term growth
For long-term investors, passive funds often make sense, considering they tend to provide higher net returns in the long run. Still, your strategy depends on your situation and doesn't necessarily look the same as that of all other passive investors.
"While passive investing makes sense for most people, it's still important to evolve your plan and your investments — how much you invest, the account you use, rebalancing, managing taxes, and adjusting risk," explains Weiss.
Active investing for market opportunities
Some investors engage in active investing to try to take advantage of market opportunities. For example, during a market downturn, you might switch from mostly stocks to bonds and then try to switch back when you think conditions will reverse. That said, accurately timing the market can be incredibly difficult, even for experienced investors.
Combining passive and active strategies
Some investors combine passive and active strategies. For example, you might primarily put your money in passive funds, such as within your retirement account, but perhaps you maintain a small pool of money in a brokerage account where you pick individual stocks that you think will outperform, knowing there's also a risk of underperformance.
Or, you might invest in some passive funds such as for stocks, while going with active funds for bonds. Much depends on your beliefs around market efficiency and your risk/reward perspective.
What is the main difference between passive and active investing?
The main difference between passive and active investing is that passive investing tries to match an index, while active investing tries to beat an index.
Is passive investing less risky than active investing?
In general, passive investing is often considered less risky than active investing because most indexes have a strong track record of gaining value over time, whereas active investing strategies that deviate from the index can be more of a wild card.
Can you combine passive and active investing strategies?
Yes, you can combine passive and active investing strategies, such as by owning some passive funds and some active funds. You might do so by choosing passive for some types of assets like stocks while active for assets like bonds.
Which is better for beginners: passive or active investing?
Many people believe that passive investing for beginners is better because you're generally getting diversified exposure, with lower risk and lower costs than comparable active funds.
Do active investors outperform passive investors over time?
Over long periods, such as five or 10+ years, passive investors tend to outperform active investors. Much depends on the specific strategies though, and the future can be unpredictable.
Tessa Campbell & Jake Safane
Passive vs. Active Investing: A Comprehensive Guide
Individual investors, especially beginners, typically take the route of passive investing, which aims to match the returns of an index or overall market and steadily build wealth over the long term, often with low fees and relatively low risk.
In contrast, more advanced or risk-tolerant investors may prefer an active investing approach that tries to outperform the market, such as by capitalizing on short-term fluctuations or finding securities that beat average returns.
Here's a closer look at how passive investing and active investing compare.
What is passive investing?
Passive investing doesn't mean that you don't care about your investments — being passive is just a strategy that essentially says markets are efficient, and over the long term, it's hard to beat the average net of fees. So, instead of trying to pick stocks that beat the average S&P 500 returns, for example, passive investing might involve buying and holding an S&P 500 index fund that in the long run potentially outperforms those trying to pick and choose investments or time the market.
Definition of passive investing
Passive investing (aka passive management) is a low-cost, long-term investing strategy aimed at matching and growing with the market, rather than trying to outperform it. With passive investing, you generally ignore the daily fluctuations of the stock market. Moreover, you hold funds or investments that aim to match the returns of an index — usually a broad-based one (or a few) that approximate the returns of the overall stock market.
You might still make some decisions, like choosing your weight of U.S. vs. international funds, but typically once you set those targets based on your goals and risk tolerance, you try to maintain those asset allocations in the belief that over the long run, your passive investments will outperform those who try to time the market or select investments that do not match index returns.
"At its heart, passive investing is a long-term investment approach where you buy a mix of stocks and bonds and other assets and hold onto them, regardless of market fluctuations," says Brent Weiss, CFP, cofounder, and head of financial wellness at Facet.
A buy-and-hold strategy is one of the most common and well-renowned passive investing techniques. Instead of trying to buy when prices seem low or sell when they seem high, a buy-and-hold strategy generally involves investing on a set schedule (like with payroll deductions going into your 401(k) every two weeks) or just investing in one lump sum.
That's because it's very difficult to know when the optimal time to buy or sell is. You might sell after a big run-up in the stock market, for example, but who's to say that prices won't climb further, causing you to miss out on more gains?
Instead, a buy-and-hold strategy requires you to keep a cool head and maintain an optimistic outlook. By holding on to the same investments over time, you're typically improving the likelihood of earning a greater return down the line compared with frequent trading.
Common passive investment vehicles
While technically it's possible to set up a passive investment strategy by buying and holding individual securities to match an index, typically this is achieved by buying investment funds. Typically, exchange-traded funds (ETFs) are passive investment vehicles, but not all are, so it's important to carefully consider the fund's strategy.
Also, among passive ETFs, there's a lot of variation in terms of what indexes they track. Some are broad-based, like those that track the S&P 500 or Russell 3000, while others are narrow, like only applying to a specific sector. So, while these narrow funds might technically be passively managed, they generally don't conform with the overall passive investment strategy of trying to match broad-based market returns (whether that's the stock market, bond market, etc.).
Another common passive investment vehicle is a mutual fund, though there are also a lot of active mutual funds, so it's important to understand what you're buying into. The main difference between ETFs and mutual funds is that ETFs are traded on stock exchanges and priced in real time, while mutual funds are managed off of exchanges by financial institutions and priced once per day after the market closes.
Sometimes for passive investing, a mutual fund makes more sense if you want to avoid the temptation to trade frequently, as ETFs are a little easier to get in and out of usually. However, mutual funds often have higher minimums, fees, and tax liabilities.
Note: Passive funds, whether ETFs or mutual funds, are often called index funds. You can't directly invest in an index, but these funds aim to match an index. Index funds typically have very low fees compared to active funds.
Pros of passive investing
There are many potential benefits to passive investing, such as:
Diversification
Passively managed funds typically invest in hundreds to thousands of different stocks, bonds, and other assets across the market for easy diversification. You're generally less susceptible to the ups and downs of the market when diversified.
Sometimes, index funds focus on a certain area of the market, such as emerging markets, large caps, or technology companies, but you're still generally gaining exposure to many assets through one vehicle. Also, index funds are typically low-cost, so it's easy to diversify by holding multiple index funds to cover different areas of the market.
That's not to say that active funds are not diversified — many are — but if you're comparing passive investing through index funds vs. choosing your own individual stocks, for example, then passive investing provides the benefit of easy diversification.
Lower risk
As a product of diversification and the buy-and-hold, long-term approach that generally comes with passive investing, this strategy is often lower risk than active investing. Some active strategies are more focused on risk mitigation, but on a general level, passive funds are considered lower risk.
Lower fees
Index funds, such as passive ETFs or passively managed mutual funds, are generally affordable investment vehicles with lower management fees and reduced trading activity than most active funds. They incur fewer trading costs and taxable events, and the management fees usually reflect how they don't require nearly as much maintenance or research as active funds do.
"It's important to remember that when it comes to investing, it's not just how much you make but how much you keep that matters. Investing with low fees and paying less in taxes means more of your money is working for you," says Weiss.
Tax management
When you trade less, as passive funds generally do, you often benefit from a tax perspective — especially when funds are held in taxable accounts, like non-retirement brokerage accounts.
"Less buying and selling of investments means fewer taxable events like capital gains, and ultimately less taxes paid by investors along the way," says Weiss.
Beginner-friendly
Passive investors and beginners generally go hand in hand, as online brokerages often offer managed portfolio options with user-friendly interfaces that allocate investors' funds into a variety of passive funds that match their risk tolerance and goals.
Higher returns on average
This benefit might seem counterintuitive because the point of active funds is to try to outperform the market. However, many studies show that passive funds outperform active funds over the long term, particularly when accounting for fees. You might have some years where active investing does better, but it's very hard for active fund managers to consistently beat the index, especially when looking at five- or ten-year returns, if not longer.
Transparency
Passive funds tend to be transparent. Typically, you can tell what an index fund or ETF invests in simply through the name. For example, Vanguard S&P 500 ETF tracks the S&P 500 index, and the Fidelity ZERO Large Cap Index Fund tracks over 500 U.S. large-cap stocks. Many active funds are also transparent, such as to comply with mutual fund disclosure rules, but some active funds like hedge funds are not transparent.
Cons of passive investing
While there are many potential benefits of passive investing, some possible downsides include:
Limited flexibility
Passive funds can be more limiting than actively managed funds. Because these track indexes, the fund manager generally can't adapt to changing market conditions. The only changes typically occur when the underlying index changes, such as when a company is added or removed from an index.
In a market downturn, for example, an active fund manager might retreat to lower-risk assets, while a passive fund would not adapt. However, this isn't always a negative, as it can position you to enjoy a market recovery.
Potentially lower returns
Although passive funds tend to have better returns net of fees on average, there's still the potential for underperformance compared to active funds. And in general, the ceiling is lower. An active fund might take on more risk for potentially higher rewards, like allocating a high percentage to a particular stock that's quickly rising.
What is active investing?
In contrast to passive investing, active investing involves making investment decisions based on the investor's or fund manager's convictions, rather than following the index.
Definition of active investing
Active investing (aka active management) is an investing strategy often used by hands-on, experienced investors who trade frequently. Unlike passive investing, which aims to match the market, active management's goal is to outperform the market, often through a combination of picking investments that differ from the index, weighting assets differently than the index does, and trying to time investment decisions.
Some individuals engage in active management themselves by picking and choosing investments they think will beat the index, but in many cases, investors turn to professional portfolio managers who manage active funds.
Common active investment vehicles
Both mutual funds and ETFs can be actively managed, but it varies by fund. Also, many private funds, accessible only to high-net-worth investors, such as hedge funds, are actively managed.
Pros of active investing
Active funds can potentially provide advantages over passive funds, such as:Increased flexibility and trading strategies
Active portfolio managers don't have to follow specific index funds or pre-set portfolios. Instead, active fund managers can pick and choose investments as they see fit and respond to real-time market conditions in order to try to beat benchmarks.
Also, rather than only utilizing the buy-and-hold philosophy to grow wealth in the long run, active investors can implement other trading strategies like shorting stock or hedging. Shorting stock is when an investor essentially bets on the price of the stock dropping. Hedging is a risk management strategy to protect investors against potential losses. That said, these strategies are often used by more specialized active funds, not all.
In general, passive investing is considered lower risk, but sometimes the flexibility means that active funds carry lower risk than passive index funds, such as if they engage in substantial hedging. Ultimately, it depends on the strategies.
If you're considering managing your investment portfolio yourself, make sure you are equipped with a meticulous level of financial knowledge and economic expertise. However, even experts struggle to beat the market over the long term, so don't assume you'll beat the market.
More tax-loss harvesting opportunities
Although active management often results in more taxable events, it's also possible that a portfolio manager engages in a specific strategy known as tax-loss harvesting to lower your tax liability. Tax-loss harvesting is when you sell securities, like stocks or ETFs, at a loss to offset capital gains elsewhere in your investment portfolio. While some robo-advisors or financial advisors offer this feature as a slight tweak to traditional passive strategies, active managers sometimes make it more of a focal point to try to improve net returns.
Potential for higher returns
With higher risk comes a higher chance of reward. Although there's often a greater chance that you'll lose your money by trying to outperform the market — and usually passive outperforms active in the long run — the rewards can be higher if you succeed. Similar to gambling, the chance of hitting it big may be enticing to some.
Cons of active investing
In contrast to some of these possible advantages to active investing, there are possible downsides, such as:
Lower long-term returns
Despite the potential to outperform the market, active tends to underperform passive when looking at long-term results.
"It's important to note that research shows that people and fund managers do beat the market from time to time. However, the vast majority of investors do not consistently beat the market over long periods of time," says Weiss. "In reality, any edge they may create is often eliminated by the additional fees they charge, the trading costs they incur, and the higher taxes they create."
Increased risk
Active investing often attempts to benefit from short-term price fluctuations by implementing trading strategies like short-selling and hedging. When active fund managers are successful, the returns can be great. But when they aren't successful, you could not only underperform passive but also lose significant money.
Higher fees
Active fund managers tend to charge higher fees since this strategy requires a higher frequency of trading and more specialized expertise. The difference might not look like much, with annual expense ratios for actively managed funds often ranging from around 0.5% to 1.00%, compared to passively managed expense ratio fees from around 0% to 0.5%. Still, over many years and as portfolio amounts grow, the higher fees of active can massively cut into returns.
More taxable events
Although some active managers engage in tax-loss harvesting to the benefit of investors, many active funds end up doing the opposite.
"Active investing creates more taxable events (e.g., capital gains) for investors, which means they will pay more in taxes along the way," says Weiss.
Key differences between passive and active investing
Passive and active investing are very different strategies. Some of the key differences include the following:
Cost and fees
In general, active investing costs more than passive due to factors such as higher fund management fees, trading fees, and taxable events. Also, active funds sometimes have higher investment minimums than passive funds.Risk and return
The consideration of risk and return between active and passive can vary a lot based on the fund, but to generalize, active has a higher risk/return profile than passive typically. There's the potential for active to outperform the market and have very high returns, although there's often a higher risk of losses. More importantly, the risk of active is that in the long run, passive tends to have higher net returns. You might get lucky and outperform, but the odds generally aren't in your favor.
Time commitment
Passive tends to be more associated with buy-and-hold, long-term investing, although plenty of active investors are long-term investors too. Still, active is sometimes used as a short-term strategy, such as to try to take advantage of certain market conditions that someone thinks they can exploit.
Market efficiency
In general, passive investors believe that markets are efficient, meaning that prices accurately reflect fair values based on all available information, with risk/reward constantly priced in. For example, you might think that a new tech company's stock will soar in value, and thus become an active investor by buying a lot of shares to tilt your portfolio in that direction. Yet a passive investor generally believes that the tech company's stock price already reflects the potential for future growth, so you're not necessarily gaining an advantage by investing now.
In contrast, active investors often believe that there are informational inefficiencies that they can exploit. For example, a stock analyst at an active fund manager might hypothesize that other investors are not paying attention to a company's potential to expand into new markets, and thus the stock price could be undervalued. Thus, picking that stock, rather than just following the index, could lead to outperformance.
Neither theory is definitively right or wrong. It depends on what you believe. Also, many experts suggest that certain areas of the market, such as large-cap stocks, tend to be more efficient, while less-covered sectors may offer more opportunities for active investors.
Which strategy is right for you?
Both passive and active investing strategies have their pros and cons. Picking the best strategy between passive or active investing depends on your circumstances and convictions. Some ways to approach the issue include:
Passive investing for long-term growth
For long-term investors, passive funds often make sense, considering they tend to provide higher net returns in the long run. Still, your strategy depends on your situation and doesn't necessarily look the same as that of all other passive investors.
"While passive investing makes sense for most people, it's still important to evolve your plan and your investments — how much you invest, the account you use, rebalancing, managing taxes, and adjusting risk," explains Weiss.
Active investing for market opportunities
Some investors engage in active investing to try to take advantage of market opportunities. For example, during a market downturn, you might switch from mostly stocks to bonds and then try to switch back when you think conditions will reverse. That said, accurately timing the market can be incredibly difficult, even for experienced investors.
Combining passive and active strategies
Some investors combine passive and active strategies. For example, you might primarily put your money in passive funds, such as within your retirement account, but perhaps you maintain a small pool of money in a brokerage account where you pick individual stocks that you think will outperform, knowing there's also a risk of underperformance.
Or, you might invest in some passive funds such as for stocks, while going with active funds for bonds. Much depends on your beliefs around market efficiency and your risk/reward perspective.
FAQs about passive investing vs active investing
What is the main difference between passive and active investing?
The main difference between passive and active investing is that passive investing tries to match an index, while active investing tries to beat an index.
Is passive investing less risky than active investing?
In general, passive investing is often considered less risky than active investing because most indexes have a strong track record of gaining value over time, whereas active investing strategies that deviate from the index can be more of a wild card.
Can you combine passive and active investing strategies?
Yes, you can combine passive and active investing strategies, such as by owning some passive funds and some active funds. You might do so by choosing passive for some types of assets like stocks while active for assets like bonds.
Which is better for beginners: passive or active investing?
Many people believe that passive investing for beginners is better because you're generally getting diversified exposure, with lower risk and lower costs than comparable active funds.
Do active investors outperform passive investors over time?
Over long periods, such as five or 10+ years, passive investors tend to outperform active investors. Much depends on the specific strategies though, and the future can be unpredictable.
