Passive Investing Explained
Passive Investing is a long-term buy-and-hold strategy that requires investors to remain always invested without hedging their portfolio or trying to anticipate stock market’s moves. Passive investing is a very cost-effective way to invest because it limits the number of trades (and fees) over time.
Passive investors usually stick to a simple buy and hold investing strategy, such as the dogs of the dow, or they buy and hold ETFs to follow the most famous indexes like the S&P 500 or the Dow Jones Industrial Average (DJIA). If these indexes make some change to their components, the ETF that matches them mechanically adapts its holdings—it sells the security that leaves the index and buys the one that’s entering it. That’s why a company usually realizes huge gains when it is included in an index—It will be added to hundreds of important funds.
Owning small parts of hundreds of businesses, you grow your wealth thanks to the overall growth of large corporations’ profits. Wealthy passive investors ignore markets’ volatility and short-term stories and focus just on their long-term goal—make their wealth grow with low efforts and low fees.
Active Investing Explained
On the other hand, active investing is the approach used by most famous portfolio managers that seek to outperform the market by actively selecting the best-performing companies in the world. Active investors’ goal is to realize above-average profits, exploit volatility, and take full advantage of every stock market’s fluctuations.
It requires much more effort and in-deep analyses that depend upon the expertise to analyze different types of investment securities and anticipate stock markets’ moves. That’s why portfolio managers are usually supported by a team of quantitative and qualitative analysts that try to investigate every piece of data and information to determine why, when, and where prices will fluctuate.
Active Investing Drawbacks
While gaining above-average returns and beat the market looks like a great feeling, that’s far easier said than done and also involves several drawbacks:
- High fees: According to Thomson Reuters, active equity funds have a mean expense ratio of 1.4%, versus the much smaller 0.6% of passive stock funds. That happens because active trading involves much more transaction costs, together with the cost of analysts’ payrolls. While researching stocks could provide investors with higher nominal returns, all those costs could damage returns over the long-term.
- Expensive Software: To properly research stocks, active investors need to spend thousands of dollars each year to have access to data providers and research platforms. For example, a Bloomberg Terminal subscription comes at $24k a year. Individual investors can use alternative stock research platforms, like Finbox, which provides investors with everything they need while being much cheaper.
- Active risk: While active managers seek to buy any securities, they believe can bring above-average returns, they can often be wrong and get terrible returns. Indeed, there are hundreds of research that show how active funds tend to underperform the market.