Investing Fundamentals: Active vs. Passive Investing

Do you like to be hands-on with your investments, where you’re on the field with the coaches? Or do you prefer to watch from the sidelines, putting money in steadily but not trying to beat the market? These strategies, called active and passive investing, respectively, are two investing approaches that could help you reach your money goals in different ways. 

Active investors buy and sell assets in an effort to outperform the market. Passive investors take a buy-and-hold approach, limiting the number of transactions they carry out, and typically try to match, rather than beat, the market. 

You may be wondering which approach might work for you. The answer depends on your savings goals and comfort level. Understanding the benefits and drawbacks of both strategies, as well as the importance of having a diversified portfolio can help you decide which investment style to use and when. 

What is passive investing?

Passive investing is a less-involved investing strategy and focused more on the long-term. Passive investors aren’t trading in an attempt to profit off of short-term market fluctuations. Instead, they add money to their portfolios at regular intervals, whether the market is up or down. Passive investors believe it’s hard to beat the market, but if you leave your money in, over time you could get a solid return with lowers fees and less effort. 

One of the most common ways to invest passively is to buy index funds – these are pre-selected collections of securities, like stocks and bonds, that are designed to track the performance of a particular index. Let’s say you purchase a passively-managed index fund that mimics the performance of the S&P 500 Index —if the S&P 500 gains 10% in a year, the index fund will also gain a similar amount. Keep in mind that fees associated with the fund will result in a lower gain. 

What is active investing?

Active investing is a more hands-on investment approach that involves watching the market and making changes to a portfolio based on what will bring the greatest potential returns given market conditions. Active investors do a lot of research, evaluate how market trends, the economy and politics might impact the best time to buy or sell. While this may seem straightforward, even advanced portfolio managers typically can’t out-perform the markets. 

An example of a popular active investment product is a mutual fund, which can include stocks, bonds, and money market instruments. Unlike index funds, which track and watch index movements from the sidelines, a mutual fund is managed by a money manager who makes trades actively. 

Pros and cons of passive investing

If you think passive investing sounds too passive, know that being a spectator can have its merits. According to Morningstar, passive investing strategies for most investors can perform just as well, if not better, than active ones — only 23% of all active funds beat the average of their passive rivals over the 10-year period ending June 2019.

But that’s not the only benefit of a passive approach. Other reasons to consider this investing strategy include: 

• Lower fees: As these funds lack an active manager, passive investing may result in less overhead, and therefore fewer and lower fees 
• Tax efficiency: Since passive investors are not selling regularly, they are typically not subject to large annual capital gains taxes 
• Transparency: Assets in a fund are clearly defined

As with any form of investing, the passive strategy may have drawbacks, which include:

• Less control over your portfolio: With a passive strategy, you’re buying into a collection of securities, so you won’t be able to make adjustments if certain sectors or companies become too risky or are underperforming
• Potentially smaller short-term returns: Passive investments typically never outperform the market, so you might miss out on larger short-term gains 

Pros and cons of active investing 

With active investing, the goal is to beat the stock market’s average returns by taking advantage of price fluctuations in the market. When you hire a fund manager or invest through robo-advisors, you’re trusting them to do this for you. And if you like even more of a hands on approach, you can do the trades yourself.

Some benefits of active investing include: 

• More flexibility: With active investing, portfolio managers and investors aren’t required to hold certain stocks and bonds, so they can take advantage of short-term trading opportunities
• Risk management: Active investors can avoid certain holdings and market sectors

Some drawbacks of active investing could include: 

• Higher fees: As you’re paying someone to monitor the market and manage your money, active investing can be more expensive  
• Fund performance: There’s no way to predict how well a fund will perform. No matter the level of experience, neither you nor the person managing your money can predict the future

How to get started with an investment strategy  

While both passive and active investing strive to earn you the best returns, there’s debate about whether being hands on or off will get the job done more effectively. Which approach you choose will depend on your goals, timeline and how confident you feel about you or a portfolio manager’s abilities to time the market. And it’s important to know that the same types of funds can be managed in different ways. For example, you could have an actively managed mutual fund made up of the top 100 companies in the S&P 500 Index, or a passively managed mutual fund that includes all 500 stocks listed in the S&P 500.

A mix of both passive and active investing is possible

There’s no one-size-fits-all approach to investing – perhaps, you’ll determine that a mix of both strategies could fit into your goals.

You can also take a more active approach to your passive investments by adjusting your investment objectives, a strategy called tactical asset allocation, and making sure elements like the stock-to-bond ratio help maximize returns and match your overall comfort level. This may give you some level of control when market conditions are volatile.

We encourage you to reach out to your Goldman Sachs team if you have any questions.