Choosing Between Active and Passive Investing I Investing 101 I Kristal.AI

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Active vs. Passive Investing – Understanding Investing Jargons

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As is the case with your goals for investment, your style of investing is also quite personal. While you may meet many advisors that pitch the benefits of active investing to you, you may find yourself feeling overwhelmed by the idea of constantly striving to stay on top of the market.

Similarly, you may find yourself in the opposite end of the field – wondering why advisors keep asking you to remain passive when all you want is to be more proactive with your money. However, while your own personality traits will determine your investing style, you must understand the pros and cons of both so that you can take active steps in order to fall into the category that suits your needs the most. In this article, we will discuss what active and passive investing mean, as well as how you can benefit from each.

What is Active Investing?

Active investing, as you may have guessed, requires a hands-on approach when it comes to your investments. In this style of investing, one requires a portfolio manager constantly keeping one eye on the market and another on your funds. With active investments, investors and their managers aim to beat the stock market, and benefit from any short-term fluctuations that may come across their way.

One of the reasons why investors need portfolio managers in the case of active investing is because these professionals are equipped to analyse the market at a deeper level to help make decisions regarding pivoting in and out of stocks, bonds and other assets.

As someone who is new to the world of investments, you may find the task of qualitative and quantitative analyses that points towards future fluctuations in the market quite challenging.

What is Passive Investing?

While active investors have no qualms about selling stocks and shares as soon as they anticipate drops in the market, passive investors do not share the same sense of abandon. Passive investments are geared towards long-term goals such as growing your wealth. They generally subscribe to a buy and hold mentality rather than one that focusses on selling now for profits. This can be quite challenging too as many young investors often find the dips in the market quite intimidating, and they sell their shares to prevent losses. These decisions, primarily driven by fear, are never fruitful. What investors must realise in these situations is that long-term investments (such as Exchange Trade Funds) often level out as time goes on.

Investors with multiple stocks in different companies enjoy growth and revenue when these companies also grow and profit. Thus, they do not allow short-term setbacks to influence their decisions and keep their eye on a much larger prize waiting at the horizon.

Now, having read about both, passive and active investing, you may sense that both have their own advantages. The idea of actively selling stocks and playing the stock market to grow wealthy may seem quite appealing, as does the idea of being patient for bigger prizes. How can you choose between the two investment styles? By understanding the pros and cons of each, of course!

The Pros and Cons of Active Investing!

Active investing offers the following benefits to investors:

  • You do not have to restrict yourself to specific indexes while choosing the funds you want to invest in. If you believe you’ve found a great ‘undiscovered’ stock, you are welcome to put your faith in it while the prices are still low.
  • You can follow hedging tactics like put options and short sales. You can also exit any stock at any time you like if you feel that the risks of the same have increased exponentially. Passive investors, on the other hand, are stuck with the stocks that belong to their index, irrespective of the overall performance of the same.
  • You can enjoy a certain level of flexibility with regards to your capital gains tax by selling stocks are that underperforming and reducing your tax liability.

Having said that, active investing also has its fair share of disadvantages. These include the following:

  • As an active investor, you depend entirely on your analyst’s abilities. Buying stocks recommended by your analyst can turn out to be very beneficial for you when they are right, but it can also be quite disastrous if they are wrong.
  • The expense ratio for actively managed funds stands at an average of 1.6% while the same for passive funds stand at an average of 0.6%. The constant flow of buying and selling leads to many transaction costs, as well as the salaries of the analysts working for your wealth. With decades of investing, this can pile up into a huge amount of money that ultimately kills your returns.

The Pros and Cons of Passive Investing!

Passive investing may suit novice investors with limited funds more than active investing due to the following advantages they offer:

  • Passive funds typically follow their index benchmarks, which is why you do not require analysts and oversight. As a result, the cost of making such investments is far lesser than the cost of active ones.
  • Passive investments offer more transparency as investors can always see what funds belong to a specific index.
  • Investors do not have to worry about high capital gains taxes as buy and hold strategies are an effective way to avoid the same.

Like active investing, however, passive investments also come with a few disadvantages:

  • Investors can sometimes find passive funds to be quite limited as they are stuck with the offerings that are included in the index they have chosen. Moreover, investors also feel locked into specific investments for a set period of time, no matter what happens externally in the market.
  • One cannot expect the high ROIs that come with active investments. These funds only track the market – they do not beat it, which is why the profits they yield are lesser than those of active investments.

Choosing Between Active and Passive Investing

With the market upheaval of 2019, more and more investors are favouring active investments over passive ones. However, if your risk appetite is low and you value security over volatility, then passive investments are more apt for you. Actively managed portfolios are also a good choice if you are into hedging, as expert portfolio managers are trained to detect subtle market movements and mine such changes for growth opportunities.

But these are broad generalisations. At the end of the day, with active investing you are paying for a trained expert’s guidance and involvement in making your money grow; while with passive investing you invest without any handholding and support. The key difference, therefore, is what you expect out of your investments and how involved you are in the process. Your needs and goals, above all, should dictate your investing style and the experts you choose to invest with.