Active investing, passive investing, or both? What to choose & why (2024)

When you delve into investing, you'll learn a lot about yourself—such as how your ability to handle risk and timelines match up with your goals. But you may also face a learning curve as you figure out what kind of investing suits you and whether that style fits your objectives.

The world of investing offers multiple levels of involvement. Broadly speaking, the approaches can be divided into active vs. passive investing—the difference between someone persistently managing and updating portfolio decisions and handpicking stocks and assets, and putting your money in a preset fund mix that doesn't demand much attention. A range of in-between options can provide a healthy balance of control and risk as well—it all depends on your investing personality and your goals.

Understanding how active vs. passive management works and exploring the advantages of the two can help give you some self-awareness as an investor. Here's how these approaches stack up.

Actively managed investments refer to investment strategies and security types where a professional portfolio manager or team of managers actively decides which assets to buy and sell. These managers typically aim to outperform a benchmark index or achieve specific investment objectives by selecting and adjusting investments based on their analysis, research and market expertise.

For example, let's say you invest in an actively managed U.S. large-cap stockmutual fund.The fund is handled by a professional portfolio manager who analyzes and selects which individual stocks will be included in the fund. The portfolio manager and their team conduct extensive research on various companies, weighing factors like business financial health, growth prospects, competitive position and industry trends.

Based on their expertise and findings, the active investing management team will decide which stocks to buy or sell and when. The manager uses this same approach continually, regularly monitoring the portfolio and ensuring the mix is still fulfilling the fund's purpose and meeting performance expectations.

The goal of the actively managed mutual fund is to outperform a benchmark index, such as the S&P 500, by selecting a portfolio of stocks they believe will deliver superior returns.

Investors may consider actively managed investments for several reasons, depending on their financial goals, risk tolerance and preferences. The most common reasons include:

• Professional management.Actively managed investments are overseen by professional portfolio managers or teams with expertise in the financial markets.
• Active decision-making.Active managers aim to outperform benchmark indices or achieve specific investment objectives by making dynamic investment decisions.
• Flexibility.Actively managed strategies can adapt to changing market conditions and seize opportunities as they arise. Managers have the leeway to buy and sell individual securities within the portfolio.
• Diversification.Actively managed portfolios are typically diversified across a range of assets, sectors and industries, which can help spread risk and reduce the impact of poor-performing assets.
• Risk management.Professional managers monitor the portfolio to manage risk and reduce potential losses. They can adjust the portfolio to mitigate the impact of market downturns.
• Specialized expertise.Some actively managed funds focus on specific asset classes, sectors or investment styles, allowing investors to access specialized expertise.
• Income generation.Actively managed fixed-income funds may aim to generate higher income by selecting a mix of dividend-paying stocks or different types of bonds with varying maturities, credit qualities and yields.
• Customization.Some actively managed investments allow for customization based on individual investor needs, such as risk tolerance, tax considerations and specific investment goals.
  

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Passively managed investments, also known as index investments, involve replicating or mimicking the performance of an existing market index or benchmark that represents a pre-selected group of investments. This strategy provides investors with broad market exposure, typically at a lower cost than active accounts, because professional portfolio managers have minimal involvement.

A prime example of a passive investment is an . The S&P 500 market represents 500 of the largest publicly traded companies in the United States. An S&P index fund, then, is an investment package specifically designed by a financial institution (typically a mutual fund or exchange-traded fund (ETF) provider) to replicate the performance of the larger S&P 500.

The idea is that when the S&P 500 goes up or down, the fund's value similarly rises and falls. The investors are effectively buying a piece of the entire S&P 500 index. They then have the potential to get returns that match the index's returns without having to buy each stock individually or have anyone actively manage it.

Passively managed investments have become increasingly popular in recent years, and there are several reasons investors consider them. Benefits of passive investing include:

• Lower costs.Passively managed investments typically have lower expense ratios and management fees compared to actively managed investments. This cost advantage can lead to higher net returns for investors.
• Simplicity.Passive investments are straightforward and easy to understand. They are ideal for investors who prefer a hands-off approach and don't want to spend time analyzing individual securities.
• Broad diversification.Passive investments provide broad market exposure. For example, an S&P 500 Index Fund offers diversification across 500 of the largest U.S. companies, helping to spread risk.
• Tax-efficiency.Low portfolio turnover in passive strategies means fewer capital gains distributions, making them appealing tax-efficient options for investors.
• Ease of access.Passive investments are easy for investors to access because they're available in various forms, including mutual funds, exchange-traded funds and index certificates.
• Behavioral benefits.Passive strategies can help investors avoid impulsive trading and behavioral biases leading to poor investment decisions.

Investors often face a fundamental decision when choosing between actively managed and passively managed investments. The choice largely hinges on individual goals, risk tolerance and investment philosophy.

Those who seek the potential for out-performance and are comfortable with the possibility of higher fees may opt for actively managed investments. These individuals depend on professional managers being able to leverage market inefficiencies and deliver above-average returns. They may also appreciate the active manager's ability to adapt to changing market conditions. However, this approach comes with risks—not all active managers consistently outperform the market, and fees can erode returns.

Investors who prioritize cost-efficiency, simplicity and market predictability may lean toward passively managed investments. Passive strategies aim to capture market returns by replicating benchmark indices, offering broad diversification and transparency at lower costs. Passively managed investments generally provide benchmark-aligned returns and may be well-suited for long-term, hands-off investors seeking market exposure with minimal complexity.

While active investing strategies may be more suitable for investors wanting to outperform a benchmark, they can also be riskier and more costly than passive investing. A common strategy is to combine both approaches, using passively managed investments as core holdings while adding actively managed ones for specific goals or sectors, striking a balance between cost savings and potential performance.

Whether you use active investing, passive investing or a combination of both, it's important to assess your risk tolerance and clarify your investment objectives before making investment decisions. This is where the expertise of afinancial advisorcan be valuable in guiding your decisions.