Investing in financial markets can seem complex, full of numerous strategies and choices.
A fundamental decision investors face is choosing between an active or passive investment approach. Each has its own strengths and potential downsides.
Understanding their core differences could significantly affect your investment results and success.
Active investing – Striving for superiority
Active investing is an involved process that is often best managed by professionals. This style is commonly used by managers of funds on which many regular investment products are based.
It involves picking individual stocks, bonds or other assets in an attempt to surpass the market. This strategy usually depends on an investment manager or a team of analysts who use their expertise to research and analyse various investment options.
The aim of active investing is to outdo a specific benchmark, such as the S&P 500 or FTSE 100, rather than merely equalling its performance.
Active fund managers employ various tactics including market timing (buying or selling based on predictions of market movements) and sector rotation (shifting investments around different sectors based on their expected performance).
However, this approach comes with higher costs due to frequent trading and research expenses, which can eat into the investment returns.
Moreover, despite the hard work of fund managers, not all active funds consistently surpass their benchmarks.
Passive investing – Mirroring the market
On the other side, passive investing aims to match, not outdo, the performance of a specific market index.
This strategy involves investing in an index fund or exchange-traded fund (ETF) that replicates the holdings of an index, such as the S&P 500.
The idea is that over time, the markets will generate a positive return, and by copying the market, an investor will share in these returns.
Passive investing requires less management compared to active investing, which results in lower costs.
This lower cost is a primary advantage of passive investing and a key reason why some passive funds have outperformed their active counterparts, particularly after fees.
However, by its very design, passive investors forgo the chance of outdoing the market as they are only aiming to copy the market’s performance.
Choosing your style – passive, active, or a mix of both
So, which style is better? The answer largely depends on an investor’s personal circumstances, including risk tolerance, wider investment portfolio, and financial goals.
Active investing may suit investors who are ready to take on more risk for potentially higher returns and don’t mind paying higher fees for the chance of outperformance.
On the other hand, passive investing could be a good fit for those who prefer lower costs, are comfortable with market-level returns, and prefer a less involved approach to their investments.
Some investors may even opt for a mix of both strategies, assigning a part of their portfolio to active investments for potential outperformance, and another part to passive investments for diversification and lower costs.
Any investment carries significant risk and requires thoughtful consideration and independent professional advice. To access this advice, speak to one of our team.