Active Vs Passive Investing: What's The Difference? (2024)

Passive investing and active investing are two contrasting strategies for putting your money to work in markets. Both gauge their success against common benchmarks like the S&P 500—but active investing generally looks to beat the benchmark whereas passive investing aims to duplicate its performance.

What Is Active Investing?

Active investing is a strategy that involves frequent trading typically with the goal of beating average index returns. It’s probably what you think of when you envision traders on Wall Street, though nowadays you can do it from the comfort of your smartphone using apps like Robinhood.

“This type of investing typically requires a high level of market analysis and expertise in order to determine the best time to buy or sell [investments],” says Kevin Dugan, investment advisor and senior partner at Dugan Brown, a financial planning firm in Dublin, Ohio.

You can do active investing yourself, or you can outsource it to professionals through actively managed mutual funds and active exchange-traded funds (ETFs). These provide you with a ready-made portfolio of hundreds of investments.

Active fund managers assess a wide range of data about every investment in their portfolios, from quantitative and qualitative data about securities to broader market and economic trends. Using that information, managers buy and sell assets to capitalize on short-term price fluctuations and keep the fund’s asset allocation on track.

Without that constant attention, it’s easy for even the most meticulously designed actively managed portfolio to fall prey to volatile market fluctuations and rack up short-term losses that may impact long-term goals.

This is why active investing is not recommended to most investors, particularly when it comes to their long-term retirement savings.

Advantages of Active Investing

• Flexibility in volatile markets. “The active investor has the potential to move to a defensive position or holding, such as cash or government bonds, during down markets to prevent catastrophic losses,” says Brian Stivers, investment adviser and founder of Stivers Financial Services in Knoxville, Tenn. Similarly, investors can also reallocate to hold more equities in growing markets. By responding to real-time market conditions, they may be able to beat the performance of market benchmarks, like the , at least in the short term.
• Expanded trading options. Active investors can use trading strategies such as hedging with options or shorting stock to produce windfalls that increase the odds they beat market indexes. These also, however, can greatly increase the costs and risks associated with active investing, making them techniques best left to professionals and highly experienced investors.
• Tax management. A savvy financial advisor or portfolio manager can use active investing to execute trades that offset gains for tax purposes. This is called tax-loss harvesting. While you can certainly use tax-loss harvesting with passive investing, the amount of trading that takes place with active investment strategies may create more opportunities and make it easier to avoid the wash-sale rule.

Disadvantages of Active Investing

• Higher fees. Most brokerages don’t charge trading fees for run-of-the-mill purchases of stocks and ETFs these days. But more sophisticated, derivative-based trading strategies may incur fees. And if you invest in actively managed funds, you’ll have to pay high expense ratio fees. Because of the research and amount of trades involved, actively managed funds have relatively high expense ratios, averaging 0.71% as of 2020.
• Increased risk. When active investors are right, they stand to win big. But if one investment zigs when you zagged, it can drag down portfolio performance and cause catastrophic losses, especially if you used borrowed money—or margin—to place it.
• Trend exposure. In active investing, it’s very easy to hop on the bandwagon and follow trends, whether they’re meme stocksor pandemic-related exercise fads. Consider the investor who decided to get in on the at-home workout trend and buy Peloton (PTON) at $145 on Jan. 4, 2021. As of July 2022, that stock is now trading for less than $10 now that the pandemic is all but over. What becomes very difficult with trend-based investing is determining if you’re at the tip of the trend or if there’s still room to grow.

What Is Passive Investing?

Passive investing is a strategy centered on buying and holding assets for the long term. It’s best described as a hands-off approach: You choose a security and then you hold on through ups and downs with a longer-range goal in mind, such as retirement.

While active investing tends to focus on individual securities, passive strategies generally involve purchasing shares of index funds or ETFs that aim to duplicate the performance of major market indexes, like the S&P 500 or Nasdaq Composite. You can buy shares of these funds in any brokerage account, or you can have a robo-advisor do it for you.

• Read More: Best Passive Income Ideas

Because it’s a set-it-and-forget-it approach that only aims to match market performance, passive investing doesn’t require daily attention. Especially where funds are concerned, this leads to fewer transactions and drastically lower fees. That’s why it’s a favorite of financial advisors for retirement savings and other investment goals.

Advantages of Passive Investing

• Lower costs. The reduced trading volumes associated with passive investing can lead to lower costs for individual investors. What’s more, passively managed funds charge lower expense ratios than most active funds as there’s very little research and upkeep required. The average expense ratio for passive mutual funds in 2020 was 0.06%; passive ETFs came in at 0.18%.
• Decreased risk. Because passive strategies tend to be more fund-focused, you’re typically investing in hundreds if not thousands of stocks and bonds. This provides easy diversification and decreases the likelihood that one investment going sour tanks your whole portfolio. If you’re managing active investing yourself and lack appropriate diversification, one bad stock could wipe out substantial gains.
• Increased transparency. What you see is what you get with passive investing. In fact, often the index your fund tracks is part of its name, and it’ll never hold investments outside of its namesake index. Actively managed funds, on the other hand, don’t always provide this level of transparency; much is left to the manager’s discretion and some techniques may even be withheld from the general public to preserve a competitive edge.
• Higher average returns. If you’re investing for the long term, passive funds of all kinds almost always give higher returns. Over a 20-year period, about 90% index funds tracking companies of all sizes outperformed their active counterparts. Even over three years, more than half did, according to the latest S&P Indices Versus Active (SPIVA) report from S&P Dow Jones Indices.

Disadvantages of Passive Investing

• It’s not flashy. If you’re looking for the excitement that comes from seeing quick skyrocketing returns from a single stock, passive investing pales in comparison.
• No exit strategy in severe bear markets. Because it’s built for the long term, passive investing doesn’t have an off ramp during severe market downturns, Stivers cautions. While historically the market has recovered from every correction, there’s no guarantee that it’ll do so quickly. This is part of why it’s important to regularly revise your asset allocation over longer period. This way, you can make your portfolio more conservative as you near the end of your investing timeline and have less time to recover from a market dip.

Should You Ever Pick an Active Fund or Investing Style?

Given that over the long term, passive investing generally offers higher returns with lower costs, you might wonder if active investing ever warrants any place in the average investor’s portfolio. For certain types of investors, the answer may be yes.

Wealth Preservation

Investors who favor preserving wealth over growth could benefit from active investing strategies, Stivers says. For example, an active strategy might well serve someone close to retirement who lacks the time to recover from large losses or who is focused on building a steady stream of income instead of seeing regular long-term capital gains.

Combination Strategies

Active and passive investing don’t have to be mutually exclusive strategies, notes Dugan, and a combination of the two could serve many investors.

Investors with both active and passive holdings can use active portfolios to hedge against downswings in a passively managed portfolio during a bull market. A combination approach can also give an investor the peace of mind to know their passive, long-term strategy (like their retirement funds) is on autopilot while an active, short-term strategy (like a taxable brokerage account) lets them explore trends without jeopardizing their long-term goals.