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Active vs. Passive Investing: Why Your Investing Style Matters

What’s the difference between active investing and passive investing? What type of investor are you? Explore the pros and cons of each strategy and adjust your tactics accordingly.

Don't be overwhelmed by investing; you have options, even if you have limited time.Let’s be honest — investing can be a lot of work.

It’s easy to be overwhelmed, drowning in an endless and often-contradictory deluge of information from active trader blogs like SeekingAlpha, passive investing forums like Bogleheads.org, or even newsletters in which supposed self-made millionaires tout their “foolproof” stock-picking strategies.

Let’s just say it: Get-rich-quick-schemes aside, there’s no wrong way to invest if you can get results.

And if you have started putting money away for the future, you’ve already accomplished the hardest step.

But now you’re faced with the dilemma of how to invest. And though there may not be a wrong way to invest, different people are better suited to different investing styles.

Active vs. passive investors

When most of us think of an investor, an active investor is usually who comes to mind. This is your buddy who gets stock alerts on his phone, is always talking about how he picked up a few shares of this company or that, and who may have multiple computer monitors. Another word for this type of investor is active trader, and it includes anybody who buys and sells investments on a weekly basis with the hope that those trades will result in better overall performance.

A less visible group (although not small in numbers) are passive investors. These investors trade less frequently, often choose mutual funds or ETFs over individual company stocks and are most likely more interested in keeping their investing expenses as low as possible than trying to get in on the next hot IPO.

Which type of investor are you?

There are two questions you need to ask when deciding which kind of investing strategy to pursue:

  • How much do you want to learn about investing?
  • How much time will you have to devote to investing?

If you answer “not much” to either of these questions, the decision is easy: You either don’t want to or won’t have the time to analyze every stock you want to buy, so you should follow a passive investing strategy.

For the passive investor

A passive investment strategy is for people who don’t have the time or desire to gain a sophisticated knowledge of the stock market and investments. That’s not to say passive equals “hands-off”: Passive investing still requires some work and some knowledge to be successful.

A company 401(k) is a good example of passive investing. You pick a few mutual funds — pools of diversified investments — contribute a few dollars every two weeks, and you only change something if you stray too far from your desired asset allocation (the percentage of your portfolio invested in different asset classes like foreign or domestic stocks, bonds, etc.). For most people, reviewing this once a year is adequate.

Passive investing isn’t limited to retirement accounts. You can buy mutual funds or index funds to invest for nearly any goal.

Unlike an actively-managed mutual fund (in which professional money managers do trade actively so their investors don’t have to), index funds are not actively-managed but allow you a bit more freedom in allocating your money. Index funds simply track broad indices or sectors of the overall market — for example, the S&P 500. Some investors swear by index funds and insist they do just as well as their more expensive actively-managed competitors. (You’ll have to decide for yourself.)

Finally, passive investors can and do invest in individual stocks. This model might be something you’ve heard of before – buy and hold. The idea is that you do your homework once to find companies you anticipate doing well for the next 10 or 20 years and then sit back and watch it play out.

This strategy made a lot of people — Warren Buffet, most famously — exceedingly wealthy, but it’s getting riskier. Rapidly-changing technology means companies are much quicker to go private, get bought out, get de-listed, or even go bankrupt. If you don’t keep a careful eye on what you own, you could be holding a stack of worthless paper in 20 years. If you want to see an ugly example of this, take a look at a company that was once held in any respectable portfolio for many years until it finally claimed bankruptcy, Eastman Kodak.

It’s not to say there are not still stocks worth holding for the long run, but it would be wise to think of this strategy as buy-hold-and-review.

For the active investor

If you have the time to devote to your investing and a burning desire to master the markets, you might consider active investing. In which case, the strategies you can use are endless.

To clarify, active investing does not necessarily mean market timing, in which you try to guess what a stock will do and trade ahead of it. Although some professionals still try to time the market, most investors who do this will definitely lose.

The most common strategy in active investing is known as tactical asset allocation. Unlike strategic asset allocation – a passive investing approach that involves period rebalancing to maintain a desired allocation for the long run — tactical asset allocation advocates rotating investments into different sectors as they ebb and wane in the business cycle. Depending on market behavior, you may end up making changes once a year, every a quarter, or even on a monthly basis.

For those of you who want even more market interaction and have the time to do it, you can research your own stocks and developing a custom strategy of your own. There’s no shortage of education available for learning how to analyze a stock, anticipate market movements, and leverage money in a profitable manner.

Some people like to mix up strategies as well. You can have accounts that use the passive approach like your 401(k) or IRA, and you can also have a brokerage account that you trade with. This is, perhaps, the smartest strategy for those wanting to dabble in active investing: Build a portfolio of passive, less-risky diversified funds and then choose your own investments with 10 or 20 percent of your assets.

If you find active investing worthwhile, there are myriad professional investing newsletters to keep you updated on the latest trends and help you make better decisions.

What do you think is the most challenging part of investing for the first time? Are you an active or passive investor?

About Daniel Cross

Daniel Cross has been in the industry as an investment writer and financial advisor since 2005. He holds the Chartered Financial Consultant designation (ChFC) as well as Series 7 and Series 66 licenses, and has embarked on the arduous journey of obtaining the coveted CFA designation. Daniel lives in Florida with his wife, daughter, and pet Tortoise ironically named Turbo.