The debate between active investing and passive investing has been going on since time immemorial. An active approach to investing has its advantages. The same is true for passive investing. Both have their respective disadvantages and limitations. Which one is better? What approach to investing should you choose?
Choosing Between Active Investing and Passive Investing
The answers to the questions above depend. Passive investing is ideal for beginners or those who do not have the necessary expertise and time to monitor and evaluate the different facets of their investments. Active investing is suitable for those who have a clear goal of maximizing their earning potential in the shortest time possible.
When Passive Investing Outperforms Active Investing
Evidence revealed that investors who have chosen a passive approach to investing tend to outperform those who chose an active approach.
For example, the 2005 book “Unconventional Success: A Fundamental Approach to Investing” by American investor and fund manager David F. Swensen mentioned several studies showing that between 86 percent and 95 percent of actively managed funds throughout the early 2000s failed to deliver returns after taxes to outperform benchmarks and indices.
Another study conducted by Index Fund Advisors revealed that only about 4.5 percent of actively managed funds in the United States were able to outperform S&P indices throughout a 15-year period ending in 2021. The number dropped down to 2 percent when factoring in relevant costs such as taxes and transaction costs.
When Active Investing Outperforms Passive Investing
However, there are instances or situations in which active investing seems a better approach than passive investing.
Dan Hunt, a senior investment strategist at Morgan Stanley, explained that an active approach to investing can benefit investors when the market is volatile or if a particular economy is approaching or is currently in a recession.
The aforementioned insight comes from the fact that active investing maximizes the advantages of short-lived changes in the market. Active investors or their portfolio managers tend to buy assets or securities at a discount when the market is low and then sell them as soon as possible once the market recovers. The returns can be significant.
Deciding Between Active Investing and Passive Investing
Remember that active and passive approaches to investing have their respective advantages and disadvantages. Most advisors would encourage beginners and non-experts to take the passive approach. However, other advisors believe that the best strategy is to blend both.
Pursuing active investing and passive investing means having the best of both worlds. Doing so can help mitigate the respective disadvantages and limitations of each while maximizing their respective advantages. The active investing versus passive investing discourse should not be a debate, especially for seasoned investors.
Choosing between the two requires answering pertinent questions before one starts investing. These include determining specific and personal financial goals and objectives, capacity to invest, and individual risk tolerance.
FURTHER READINGS AND REFERENCES
- Coleman, M. 2022. “SPIVA: 2021 Year-End Active vs. Passive Scorecard.” Index Fund Advisors. Available online
- Hunt, D. 2022. “A New Take on the Active vs Passive Investing Debate?” Morgan Stanley. Available online
- Swensen, D. F. 2005. Unconventional Success: A Fundamental Approach to Investing. Simon and Schuster. ISBN-13: 9780743228381
