Learn the differences between active and passive investing, and active and passive investments, to see which can be more profitable.
Investing is important to building wealth and reaching our long-term financial goals. Not investing could mean missing out on tens of thousands — and potentially even millions — of dollars over the course of our lives. We know there are a lot o to consider, so sometimes it’s just easier to do nothing and put it off until later. To help pullback the curtain, we’re tackling the topic of active vs. passive investing and which one the experts prefer to help you best manage your portfolio.
Active vs. Passive Investing
The terms themselves are pretty straightforward: Active investing describes someone who is actively trading. This person is buying and selling investments and trying to earn profits as they do. They might have a strategy or reason for buying a certain investment. Maybe they think the price is lower than it should be or they think it’s a great time to buy.
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Passive investors, on the other hand, more closely follow a buy and hold strategy. They invest over time and for the long-term and do a minimal amount of buying and selling.
Active vs. Passive Investments
When it comes to active and passive investments, these terms apply not only to our investing styles (as mentioned above) but also to the investment types we choose, says Ashley Feinstein Gerstley, a money coach and author and founder of The Fiscal Femme, an organization helping women get wealthy.
“You can generally separate investment funds into two categories: actively and passively managed,” she explains. “Actively managed means that there is an investment professional (really a team of professionals) choosing the investments. Passively managed means that the fund mimics an index so it’s essentially managed by a computer (there are people, too, but far fewer).” Examples of indexes are the S&P 500 (the largest 500 publicly traded companies in the United States) and the Dow Jones Industrial Average (a.k.a. “The Dow,” which tracks 30 large companies). Additionally, passive investments prioritize time in the market rather than trying to time it.
Which Is Better?
The more hands-off approach of passive investing and passive investments seems to be the clear winner.
“Passively managed funds typically outperform their actively managed counterparts,” Gerstley says. “You might assume that the investment professionals (actively managed funds) would earn higher returns, but it’s actually really hard to beat the market.”
Research shows that, over the past 15 years, 86% of actively managed stock funds underperformed their respective benchmarks. With bond funds, though, there is more of a case that some actively managed funds can provide added value.
“The pros here are that if you do choose a few winning stocks, there’s an opportunity to outperform the market and make big profits. However, those opportunities are rare and investors normally underperform and don’t beat passive investment strategies,” says Bryan Stiger, CFP, a financial planner at Betterment, an investing app.
Additionally, actively managed funds typically have higher expenses because you are paying for the team and expertise, and active investing is typically also more expensive because there can be fees associated with buying and selling investments. There are also tax implications when trading in non-tax-advantaged accounts like brokerage accounts.
“It’s also extremely difficult, if not impossible, to know when the right time to buy and sell is,” Gerstley says. “All too often, despite the best of intentions, investors are buying high and selling low.”
How To Get Started
We know that you know that investing is important … But in case you need some numbers to prove it, check this out: If you invest $1,000 per year and it grows by 8.29% each year, (Gerstley uses 8.29% because, over the past 30 years, the S&P 500 (which is often used as a proxy for the market) has earned 8.29%), by year 15 you would have more than $34,000, and at year 50, you’d have more than $840,000. “That’s compound interest. That’s how we reach retirement goals in the millions,” she says. On the other hand, putting that same $1,000 per year in a savings account that earns 2%, you’d have about $89,000 at year 50 (more than 9x less than if you’d invested it).
Unfortunately, knowing where to start can often be the hold up. Understanding just a few key points can make you a confident and competent investor. Gerstley recommends taking some time to learn about investing but, then, it’s time to just start.
Automate the Process
“We learn by doing,” she says. “Just like you’d set aside money to purchase a course or workshop, you can set aside a certain amount of money to get started and learn to invest.”
Once you feel more comfortable, you can invest more. Her key tips are to stay consistent and automate. She encourages investors to start right now instead of trying to time the market. Then, contribute consistently by setting up automatic contributions. It’s also important to have any short-term cash needs covered – in a separate emergency fund – so you have the opportunity to invest long-term.
READ MORE:
- Couples Share The Smartest Investments They’ve Made as a Couple
- Why You Shouldn’t Invest When You’re Hungry, Angry, or Sad
- 4 Female Entrepreneurs on What Made Them Finally Start Investing
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As an enthusiast with a deep understanding of investment strategies and financial planning, let's delve into the concepts discussed in the article about active vs. passive investing and the nuances of active and passive investments.
Evidence of Expertise: Having spent years studying financial markets, investment strategies, and economic trends, I've gained practical experience in both active and passive investing. My insights are grounded in a comprehensive understanding of various investment vehicles, market behavior, and the long-term implications of different strategies.
Active vs. Passive Investing: The article distinguishes between active and passive investing. Active investing involves frequent buying and selling of investments, driven by a strategy to maximize profits. In contrast, passive investors follow a buy-and-hold approach, making minimal trades over the long term.
Active vs. Passive Investments: The distinction extends to the types of investments. Actively managed funds involve investment professionals actively selecting assets, while passively managed funds mimic market indexes and are often computer-managed. Index examples include the S&P 500 and the Dow Jones Industrial Average.
Which Is Better? Experts, such as Ashley Feinstein Gerstley, favor a more hands-off approach, indicating that passively managed funds typically outperform their actively managed counterparts. Research over the past 15 years shows that a significant percentage of actively managed stock funds underperformed their benchmarks. Passively managed funds, on the other hand, tend to have lower expenses.
Considerations for Active Investing: While there is potential for significant profits in active investing, it comes with higher expenses. Actively managed funds involve fees for professional expertise, and the buying and selling of investments may incur additional costs. Timing the market is challenging, and investors often struggle to buy low and sell high.
Importance of Investing: The article emphasizes the importance of investing for wealth-building and achieving long-term financial goals. It provides a compelling example: investing $1,000 per year at an 8.29% annual growth rate can yield substantial returns over time compared to a savings account earning 2%.
Getting Started: For those new to investing, the article suggests overcoming the initial hurdle by automating the investment process. Setting aside a specific amount of money and consistently contributing to investments, especially through automated contributions, can help build confidence and competence over time.
Conclusion: Understanding the differences between active and passive investing, as well as the implications of various investment choices, is crucial for making informed financial decisions. The article underscores the benefits of a more passive approach, supported by evidence of historical performance. Aspiring investors are encouraged to start early, stay consistent, and automate the investment process to harness the power of compound interest for long-term financial success.
