Passive vs. Active Investing – What Is the Difference?
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Unlike exercise, being passive is much more beneficial than being active when investing.
Active investing is generally more expensive because analysts and portfolio managers have to be paid, and more frequent trading adds to the cost. After accounting for expenses, active managers often fail to “beat the market,” such as achieving better returns than the S&P 500.
Still, active investing can have a place in an investment portfolio and can outperform passive investing more often when the market is volatile. Mixing both strategies can give an investor the best of both worlds.
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Active vs. passive investing
What's the difference between active and passive investing? Consider passive investing as where you put your money for a long period of time to earn slowly. For example, putting your money in low-cost mutual funds that aim to outperform the market while you sit back and do almost nothing, waiting for retirement.
On the flip side is active investing. You won't sit back and watch your money grow. Instead, you'll keep a close eye on performance and changes that may affect your earnings and move your money to more profitable places as you do both. Active investing can have high rewards but also come with higher risk. Passive investing carries a much lower risk and provides steady but slow-growing rewards.
Passive investing
Passive investing and index investing are synonymous with the mutual fund company Vanguard. The company’s founder, John Bogle, started the first index fund in 1975 to track the S&P 500.
Vanguard is well known for having low fees, and its index funds helped start that trend.
Vanguard has low fees partly because it uses index sampling to track a benchmark index without replicating all of the holdings in an index. Holding every stock in an index is expensive, and Vanguard uses sampling to replicate the performance of a benchmark index without buying every stock in an index.
Passive investing is popular among investors for the simple reason that it doesn’t require much work. With almost no research required, investors can put their money in mutual funds that mirror the stock market in investments and try to replicate the overall stock market for returns.
This type of investing became popular with retirement accounts in the late 1980s and early 1990s when employers started moving from pensions to 401(k) retirement accounts that employees managed.
Instead of buying and selling often, passive investors buy and hold index or other mutual funds for years, if not decades. Historically, this has led to passive investments earning more money than active investments.
It’s hard to beat the market, as any financial advisor will tell you, and not reacting to the stock market’s every big drop or rise can save you from trying to time your investments.
Index funds that follow the major indices like the S&P 500, Dow Jones Industrial Average, or DJIA can be bought. If the companies in either index change, the index funds automatically adjust their holdings by selling stocks that are leaving or buying stocks that are becoming part of the index.
When a company becomes big enough to be included in one of the major indices, it can affect thousands of major funds. This is one reason passive funds rely on diversification to improve their chances of beating the market average.
Active investing
Active investing is a more hands-on approach usually done by professional portfolio managers.
Their goal is to actively manage investments to beat the stock market’s average returns and profit from short-term price fluctuations in the stock market. It requires deep analysis of a particular stock or other assets and to determine when the price will change in their favor.
Active management is more popular in rising markets as more investors try to ride the wave and profit from it. This includes more people following active investment strategies on their own and managing their money.
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Passive investment strategies
Generating passive income can come in different forms: dividends, interest, and rents are a few. The idea is to build a low-cost, diversified portfolio with a low turnover that will produce an average market return without much work.
The long-term holdings should be in multiple industries, sectors, market capitalization sizes, and countries.
Another part of passive investing is regularly buying stocks, bonds, or other assets through dollar-cost averaging. You can do this by automatically transferring a certain amount of money each month to a brokerage account and automatically investing it in a mutual fund. Dividends should also be automatically reinvested.
No matter how low your holdings fall, don’t sell them as long as the fundamentals you base your purchases on still exist. This can protect you from your own irrationality.
The Vanguard 500 Index, for example, has a turnover rate of only 3%, meaning the average stock is held for 33 years.
Look for low expense ratios
Vanguard and other funds charge expense ratios as their payment for managing funds, no matter how passive they are. Vanguard has some of the lowest expense ratios in the industry.
The expense ratio is calculated by dividing the fund’s operating costs by the assets under management, or AUM. The lower the ratio, the higher a return can be over time for an investor.
Vanguard gives the example of a hypothetical investment of $50,00 over 20 years and says that assuming a 6% annual rate of return, its low expense ratios could save the investor around $24,000 in expenses.
The Vanguard Total Stock Market Index Fund, or VTSAX, has a very low expense ratio of 0.04%.
For passive or index funds, the typical expense ratio is 0.2% but can be as low as 0.02% or less in some cases, according to one analysis.
On the other hand, a reasonable expense ratio for an actively managed portfolio is about 0.5% to 0.75%. An expense ratio higher than 1.5% is considered high.
An expense ratio cost calculator can quickly show you the cost of a low ratio vs. a high one. Suppose you made an initial investment of $10,000 and contributed $5,000 to it each year for 30 years, with an investment return of 6%.
Paying 0.2% in management fees would cost you $16,805 over 30 years. Paying 1% would cost $77,312 over the same time, or $60,506 more.
Paying a higher expense ratio pulls more money out of your pocket in fees each year, and those you paid can no longer compound. Paying $1,000 in fees is $1,000 less than grows and compounds during your lifetime.
Buy exchange-traded funds (ETFs)
Exchange-traded funds, or ETFs, are a big part of passive investing. ETFs are a collection of securities, such as stocks, that often track an underlying index. They can also invest in industry sectors or use other strategies.
They’re similar to mutual funds, though ETFs are listed on exchanges like any single stock. An ETF can have several investments, such as stocks, bonds, and commodities, and has a price that can be bought and sold.
ETF prices can change throughout a trading day, while mutual funds only trade once a day after the market closes. They’re known for having low expense ratios and broker commissions.
Related: Best ETFs
Active investment strategies
Active investing is best for people with a lot of money to invest who can afford the risks of wild swings in stock prices.
If you have a lot of cash, one active investment strategy is to invest in ETFs after the market has fallen. This can create a buying opportunity for ETFs to do well before the market pulls back.
If you’re looking for income, stocks with dividend growth may be best if you’re willing to hold the stocks for a while. Dividends are cash payments companies give investors as a reward for owning the stock. Passive investors may want to reinvest the dividends in the company stock, while active investors may prefer taking the dividend as a cash payment.
Day trading is another option. Some people start this hobby and turn it into a full-time job. You may want to experiment with day trading slowly and only use the money you can lose. Don’t expect to beat the experts.
Hedge funds are actively managed by a manager, who monitors the market and trades when they see a chance to make money. A hedge fund is an investment partnership that invests pooled funds much more aggressively than mutual funds to earn higher-than-average returns.
Another active investment strategy is to invest in niche markets you’re interested in. These can be emerging companies or sectors or just rare investing opportunities you’ve seen that you want to invest in.
Short-term profit may be your goal, such as making enough money in a few weeks or months to pay for a wedding or a down payment on a home. Short-term profits can be difficult to earn, so don’t invest money you aren’t willing to lose.
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Investing apps, brokerages, and other accounts
Whether you’re going to be a passive or active investor or a little of each, you need to start by depositing money in a brokerage account or investing app so you can make trades.
Charles Schwab, Vanguard, and Fidelity are some of the biggest mutual fund companies where you can buy mutual funds and individual stocks. Some banks also offer these services.
Related: Best Brokerages for Beginners
You can also use investing apps. As little as $5 can be required to start. Some use automated software that picks funds based on your goals; others leave the trading to you.
Many investing apps have zero fees for having an account. Investments are protected by the Securities Investor Protection Corp. (SIPC).
Some investment platforms use robo-advisors instead of human financial planners. You enter information about your finances and goals, and the robo-advisor gives you investing advice and invests your assets for you. They’re typically inexpensive and can be a good way to get your feet wet as an investor.
These may have no minimum balances, while others range from $1 to $5,000. Monthly costs can be free, $1, or up to 0.50% of your portfolio value.
Check out these investing apps and robo-advisors:
- Acorns – Micro investing app
- – Retirement funds and stocks
- Betterment – Robo advising with a $0 minimum balance
- E*\TRADE – Active trading platform for DIYers
- Robinhood – $0 commission investing
- Stash – Fractional share investing
Related: Best Robo Advisors
Pros and cons
These investment strategies are very different from each other. They have different timelines for when to expect results and can either be cheap or expensive depending on how often they’re used. Here are some pros and cons to consider for each:
Passive investing pros and cons
Pros
- Low fees
- Historically earn more than active investments
- You can set it and forget it
- Ideal for retirement funds
- A buy-and-hold strategy that can avoid market turmoil
Cons
- Often limited to a specific index or set of investments
- Small returns that rarely beat the market since they’re often set to track the stock market
Active investing pros and cons
Pros
- Flexibility to buy stocks and indexes that you want
- Can hedge bets through short sales and put options to make money when stock prices fall
- Can exit specific stocks or sectors when risks become too big
- Tax management benefits when selling losing investments to offset taxes on big winners.
- Easier to invest in niche markets
Cons
- Fees of 1.5% that eat away at compounding and any profits
- Active buying and selling trigger more transaction costs
- High risk
- Pay capital gains tax on profits
- Stock market volatility can hurt a portfolio quickly
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The bottom line
A mix of passive and active investing is probably best for anyone, especially new investors.
Actively trading stocks can help them learn how the stock market works and how to research a company before buying stock. Both types of investing should be done with money you’re prepared to lose, though active investing carries a greater chance of this.
Retirement planning is probably best done with passive investing. Pick a few mutual funds, such as those set to mature the year you plan to retire, and contribute to them regularly and you should have a good retirement fund.
But if you’ve just come across a large amount of money and want to risk it, actively investing it in stocks that you buy now and sell soon after it has hopefully risen a lot in price can be an exciting way to make your money work for you.
A little of each, however, may be better.
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Writer
Aaron Crowe is a freelance journalist who specializes in personal finance writing and editing. He has worked at newspapers, where he won a Pulitzer Prize, and has written for numerous online publications. These include AOL, US News & World Report, WiseBread, Bankrate, AARP, and many websites focusing on housing, credit and insurance. He lives in California with his wife and daughter.
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