Updated November 8, 2023
Difference Between Active vs Passive Investing
In Active vs Passive Investing, active investing is when investors invest money only for a short-term to get high returns using a strong strategy. However, in passive investing, investors focus on making long-term investment for future profits.
The objective of active investing is to outperform the market. In underactive investing, investments are selected based on an independent assessment of the value of individual assets, and an investor is always on the lookout for short-term price fluctuations. It involves extensive fundamental and /or technical analysis, and micro and macroeconomic factors influencing the investment are closely monitored. At the end of the spectrum, you will find hedge funds that embark on aggressive investing involving high leverage levels and focus on absolute returns rather than following the benchmark performance.
This involves high risk since there is always the possibility that the investor’s/fund manager’s viewpoint will not materialize. You must be very good at picking up the right stocks at the right time. Also, this takes up considerable time to track the best investments and a high level of expertise and risk-taking attitude.
Passive investing is a more balanced investment approach to match market performance. Passive investing has a long-term focus and ignores short-term market ups and downs. A passive investor limits his portfolio’s buying and selling activities in response to changing composition in the tracked index to be matched. This is, thus, a more cost-effective way to invest and avoids short-term temptations or setbacks in price. A good example of passive investing is buying an index fund wherein the fund manager switches holdings based on the changing composition of the index being tracked by the fund. The fund strives to match the index return rather than focusing on absolute returns.
Head To Head Comparison Between Active vs Passive Investing (Infographics)
Below is the top 10 difference between Active vs Passive Investing:
Key Differences Between Active vs Passive Investing
Both Active vs Passive Investing are popular choices in the market; let us discuss some of the major differences:
- Active investing is an investment approach involving extensive research while choosing investments to beat the broad market index. Passive investing is an investment approach that determines all the assets that constitute the overall market index (selected) to match the broad market (selected index) performance
- Active investing involves fundamental/technical analysis for picking up investments. Passive investing consists of picking up investments based on a composition of the market index, which is comparatively a less risky approach to investing
- Active investors consider markets inefficient and are more interested in taking advantage of short-term price fluctuations, while passive investors consider needs efficient. Hence they ignore short-term volatility and have a long-term buy-and-hold strategy.
- Active investing involves a high volume of transactions due to frequent buying and selling activities. Hence the operating costs and capital gains taxes are high. Passive investing involves a comparatively lower volume of transactions and, therefore, is more tax-efficient and involves lower operating costs
- Active investing could involve a range of strategies: shorting, borrowing money for investments, using derivatives for hedging/speculation, arbitrage, etc. Passive investing requires limited use of strategy while matching the benchmark returns.
Comparison Table of Active vs Passive Investing
Here are some of the Comparison between Active vs Passive Investing –
|
Basis of Comparison |
Active Investing |
Passive Investing |
| Meaning | Investing based on an independent analysis of the value of each investment | Investor portfolio is formed by matching the market portfolio |
| Investment objective | To beat the market performance, focus on absolute returns | To match the market (tracked index) performance, focus on relative returns |
| Investor perception of a market | Perceive markets to be inefficient | Perceive markets to be efficient. |
| Transaction frequency | Comparatively higher, with a lot of buying and selling | Comparatively lower, switching holdings based on changes in index composition |
| Risk-Return Trade-off | Higher returns but riskier | Lower returns but less risky |
| The cost involved | Higher operating costs | Comparatively lower operating costs and tax efficiency. |
| Long term vs short term | Takes advantage of short-term price fluctuations | Ignores short-term fluctuations and long-term investment focus. |
| Expertise required | Superior skills needed to identify price discrepancies, arbitrage opportunities, and fundamental /technical assessment of stocks | Requires little decision-making by a manager and time savings due to less research and analysis involvement. |
| Portfolio composition | More concentrated portfolios with fewer securities than a broad market index | All securities of market index held to match market performance |
| Flexibility in investing | Highly flexible involves strategies like shorting, using derivatives, hedging, leverage, arbitrage, etc. | Low flexibility, the strategy involves buying and selling based on changes in index composition and suffers from market volatility due to the limited strategy use. |
Conclusion
In this Active vs. Passive Investing article, we have seen Active investing has the potential to earn higher returns than the market. However, this involves higher costs, taxes, and time for research alongside higher risk due to uncertainty in realizing investment expectations. In contrast, passive investing has the potential to consistently earn the equity risk premium with a low-cost exposure and less research involved in matching the market portfolio. Still, this approach needs to pay more attention to the market inefficiencies, hence the possibility of higher returns and outperforming the benchmark.
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