Active vs. Passive Investing: What's the Difference? (2024)

Active vs. Passive Investing: An Overview

An active investor is someone who buys stocks or other investments regularly. These investors search for and buy investments that are performing or that they believe will perform. If they hold stocks that are not living up to their standards, they sell them.

A passive investor rarely buys individual investments, preferring to hold an investment over a long period or purchase shares of a mutual or exchange-traded fund. These investors tend to rely on fund managers to ensure the investments held in the funds are performing and expect them to replace declining holdings. Fund managers can be active or passive investors.

While passive investing is more prevalent among retail investors, active investing has a prominent place in the market for several reasons.

Active Investing

Active investing, as its name implies, takes a hands-on approach and requires that someone act as a portfolio manager—whether that person is managing their own portfolio or professionally managing one. Active money management aims to beat the stock market’s average returns and take full advantage of short-term price fluctuations.

It involves a deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond, or asset. A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors and then utilizes established metrics and criteria to decide when and if to buy or sell.

Active investing requires analyzing an investment for price changes and returns. Familiarity with fundamental analysis, such as analyzing company financial statements, is also essential.

Passive Investing

If you’re a passive investor, you invest for the long haul. Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality, which means selecting stocks or funds and resisting the temptation to react or anticipate the stock market’s next move.

The prime example of a passive approach is buying an index fund that follows a major index like the or Dow Jones Industrial Average (DJIA). Whenever these indices switch up their constituents, the index funds that track them automatically adjust their holdings by selling the stock that’s leaving and buying the stock that’s becoming part of the index. This is why it’s such a big deal when a company becomes large enough to be included in one of the major indices: It guarantees that the stock will become a core holding in thousands of significant funds.

When you own fractions of thousands of shares, you earn your returns simply by participating in the upward trajectory of corporate profits over time via the overall stock market. Successful passive investors keep their eye on the prize and ignore short-term setbacks—even sharp downturns.

Advantages and Disadvantages of Passive Investing

There are several strengths and weaknesses of passive investing.

Passive Investing Advantages

Some of the key benefits of passive investing are:

• Ultra-low fees: No one picks stocks, so oversight is much less expensive.Passive funds simply follow the index they use as their benchmark.
• Transparency: It's always clear which assets are in an index fund.
• Tax efficiency: Their buy-and-hold strategy doesn't typically result in a massive capital gains tax for the year.

Passive Investing Disadvantages

Proponents of active investing would say that passive strategies have these weaknesses:

• Too limited: Passive funds are limited to a specific index or predetermined set of investments with little to no variance; thus, investors are locked into those holdings, no matter what happens in the market.
• Small returns: By definition, passive funds will pretty much never beat the market, even during times of turmoil, as their core holdings are locked in to track the market. Sometimes, a passive fund may beat the market by a little, but it will never post the significant returns active managers crave unless the market itself booms.
• Reliance on others: Because passive investors generally rely on fund managers to make decisions, they don't specifically get to say in what they're invested in.

Advantages and Disadvantages of Active Investing

There are also several strengths and weaknesses of active investing.

Active Investing Advantages

Advantages to active investing:

• Flexibility: Active managers aren't required to follow a specific index. They can buy those "diamond in the rough" stocks they believe they've found.
• Hedging: Active managers can also hedge their bets using various techniques, such as short sales or put options, and they can exit specific stocks or sectors when the risks become too big.
• Tax management: Even though this strategy could trigger a capital gains tax, advisors can tailor tax management strategies to individual investors, such as by selling investments that are losing money to offset the taxes on the big winners.

Active Investing Disadvantages

But active strategies have these shortcomings:

• Very expensive: The Investment Company Institute pegs the average expense ratio at 0.68% for an actively managed equity fund, compared to only 0.06% for the average passive equity fund. Fees are higher because all that active buying and selling triggers transaction costs, and you're paying the salaries of the analyst team researching equity picks. All those fees over decades of investing can kill returns.
• Active risk: Active managers are free to buy any investment they believe meets their criteria
• Management risk: Fund managers are human, so they can make costly investing mistakes.

Is Passive or Active Better?

So, which of these strategies makes investors more money?You’d think a professional money manager’s capabilities would trump a basic index fund. But they don’t. If we look at superficial performance results, passive investing works best for most investors. Study after study (over decades) shows disappointing results for active managers.

Active mutual fund managers, both in the United States and abroad, consistently underperform their benchmark index. For instance, sesearch from S&P Global found that over the 20-year period ended 2022, only about 4.1% of professionally managed portfolios in the U.S. consistently outperformed their benchmarks.

All this evidence that passive beats active investing may be oversimplifying something much more complex, however, because active and passive strategies are just two sides of the same coin.

While passive funds still dominate overall due to lower fees, some investors are willing to put up with the higher fees in exchange for the expertise of an active manager to help guide them amid all the volatility or wild market price fluctuations.

So which do you choose? Many professionals blend these strategies to take advantage of the strengths of both.

Active and Passive Blending

Many investment advisors believe the best strategy is a blend of active and passive styles, which can help minimize the wild swings in stock prices during volatile periods. Passive vs. active management doesn’t have to be an either/or choice for advisors. Combining the two can further diversify a portfolio and actually help manage overall risk. Clients who have large cash positions may want to actively look for opportunities to invest in ETFs just after the market has pulled back.

Retirees who care most about income may actively choose specific stocks for dividend growth while still maintaining a buy-and-hold mentality. Dividends are cash payments from companies to investors as a reward for owning the stock.

Moreover, it isn’t just the returns that matter, but risk-adjusted returns. A risk-adjusted return represents the profit from an investment while considering the risk level taken to achieve that return. Controlling the amount of money that goes into certain sectors or even specific companies when conditions are changing quickly can actually protect the client.

For most people, there’s a time and a place for active and passive investing over a lifetime of saving for major milestones like retirement. More advisors wind up combining the two strategies—despite the grief each side gives the other over their strategy.

The Bottom Line

Passive investing is buying and holding investments with minimal portfolio turnover. Active investing is buying and selling investments based on their short-term performance, attempting to beat average market returns. Both have a place in the market, but each method appeals to different investors.