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What is active investing vs passive investing?

There is a lot of talk these days about active vs passive income. Active income brings to mind images of grinding away at a tedious office job for long hours, year after year just to earn barely enough to buy food, pay the rent, and clothe the children. Passive income on the other hand evokes images of lounging on a terrace on a Caribbean island sipping cocktails as the sun sets over the sparkling azure blue sea. You glance down at an app on your smartphone and see that you’ve earned another few hundred dollars since you last checked just before dessert was served. So you ask, what is active investing vs passive investing and can I please have the passive one and reserve my spot on the terrace watching the sunset already.

Active vs passive investing

There are similarities of course between active and passive income and investing. But unlike a discussion over active and passive income, which is frankly used more frequently to draw gullible audiences into some get-rich-quick scheme or other, active and passive investing are real things.

OK, that isn’t fair. There is such a thing as passive income. Passive income is a stream of income you get after you’ve done all the long hours of work and struggle usually building an income-generating asset such as a business that once set up runs with little maintenance. But for our purposes here, we are considering active investing compared with passive investing.

How active?

Interestingly, most people have an image of a successful investor as being someone who expends a great deal of time, energy, and attention on the craft of investing. Exposed as we all are to the vast financial media machine that talks about stocks, bonds, options, futures, forex, cryptocurrencies, charts, bullish and bearish trends bombarding us from the internet, TV ads, magazines and newspapers, it is easy to form the assumption that active hands-on investing yields the best results.

Quick aside – It doesn’t matter whether it is you, the investor or a fund manager doing the trading, if trading decisions are being made on an ongoing basis trying to beat the market then it is active investing.

After all, we could say to ourselves, why shouldn’t investing be like any other highly professional skill like a microbiology, rocket science or brain surgery that takes years of study and practice.

So here’s a question. If that were so obviously the case why would there be debate over the merits of active vs passive investing? There is no public debate that I am aware of over professionally qualified brain surgery vs an amateur backstreet variety.

That’s easy, you could say. The whole idea that passive investing could be a thing and a thing that succeeds is just another example of some huckster hype to get gullible souls to sign up for another get-rich-quick scheme on a promise that they can amass a fortune, passively. That’s a good point I admit.

It feels like I am arguing on both sides of the case here, and maybe I am. But trying to swim against a current of popular assumptions can be challenging.

NYSE

How passive?

Passive investing is following a routine automated investment plan that requires no thought or decision process after you’ve decided to put it in motion. The simplest, and in many ways most effective is to set up automated payments from a checking account for example into an index-linked fund that just automatically mimics the composition of a market index, whichever index that may be.

Passive investing used to be possible only for investors with large enough portfolios of stocks to achieve the level of diversification necessary to mimic a market index. In the 1970s index-linked mutual funds were available and then in the early 1990s ETFs mimicking the major indices were available making the whole business cheaper and more accessible for all of us. To learn more about ETFs, check here.

Passive investing adopts a buy and hold strategy and doesn’t try to time the market. The passive investor accepts the market downturns that come from time to time but takes a long-term view. Over the long-term, the market will return somewhere around 15 percent a year as long as you just stick with it. If you want to check what the long-term performance of the US stock market looks like, check here.

The long-term buy and hold nature of passive investing has advantages. Because most of the stock positions held in the fund will not change much from year to year and will mostly be held for many years, most of the fund’s gains will be capital gains taxed at a lower rate than income. It is also easy to set up a passive fund in a tax-deferred or tax-advantageous retirement fund.

How do they compare

Setting aside the glamour of high-flying stock trading, actively managed funds offer the possibility of beating the market. However, that same possibility can be a trap and it comes at a cost in the form of management fees.

The fee structures of funds is usually set percentages of the asset holdings deducted every year. The percentage scales may be tiered with the percentage dropping to a minimum of a range as the value of your holdings exceeds a maximum but the principle of the annual fee structure based on the total value of holdings tends to be fixed.

Actively managed funds attract investors on the basis of their track record. In some respects, the fee structure encourages fund managers to ensure that they benefit to the maximum from any bull market but not necessarily that they take care to avoid losses during a bear market. Let’s remember, the fund manager’s fees are based on the value of investments under management so a 25 percent drop in a big bear market is something to worry about but not as much as the risk of missing out on a bull market that adds 70 percent to stock valuations.

And that is another aspect of investing in an actively managed fund. That is rather than investing in a stock of a company run by a management team you will be investing in the skill of usually a single individual fund manager. Well, you will have to hope that the fund manager will be consistently having good days and very few bad days and that he or she stays on course.

Passive investing 30 year results

Active investing – the pros and cons

The pros of active investing are

  • flexibility, and
  • the opportunity to beat the market.

The cons of active investing:

  • fees that erode your gains, unless you do it yourself, and
  • the possibility of underperforming the market.

Passive investing – the pros and cons

The pros of passive investing:

  • runs automatically with no maintenance
  • achieves predictable gains over the long-term
  • low cost
  • tax advantages

The cons of passive investing are

  • no chance to beat the market
  • lack of flexibility

Active vs passive investing performance

As noted above the attraction of active investing is the possibility to out-perform the market.

The fact is that over any long-term of about 10 years or more, most active funds under-perform the market and hence equivalent passive funds. 1)Wharton, University of Pennsylvania, Executive Education, Newsletter, Active vs. Passive Investing: Which Approach Offers Better Returns?

There will be other considerations for high worth individuals that could lead them to actively managed funds such as hedging the risks of losses but for most investors building a long-term nest egg, investing in one or more passive index-linked funds is most likely to yield the best results.

Here is a single-page summary of this article. You can download it here.

Active vs passive investing summary

I hope you found this explanation interesting and useful. Do leave me a comment, a question, an opinion or a suggestion and I will reply soonest. And if you are really inclined to do me a favor, scroll down a bit and click on one of the social media buttons and share it with your friends. They may just thank you for it.


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References

References
1 Wharton, University of Pennsylvania, Executive Education, Newsletter, Active vs. Passive Investing: Which Approach Offers Better Returns?

Andy

32 Comments

  1. Hey Andy, this is some really great information on active and passive investing. I like what you say about them, and at the end of the day like you say, they both require work, whether upfront or on an ongoing basis. What are your thoughts on forex. Would you say that it’s a desirable form of active investing if you know what to do?

    • Hi Mikhail and thanks for the comments. I am glad you liked the article. As far as I know Forex is pretty much a zero sum game. So one person’s gain is someone else’s loss. I know many people are very active investing in Forex and some people manage to make money on it. I have never tried myself but maybe I am missing an opportunity. Thanks again for the comment. Kind regards, Andy

  2. Great post. I am looking at ways to receive passive income. Putting in the work during spare time and receiving income is good news. I think people just don’t understand the hard work which must be put into first to be successful.

    • Hi Brian, just passive income does sound very attractive but I think experience shows that the passive part only comes after an active part. May you active part be short and easy and may your passive part be long and profitable. Best regards, Andy

  3. Hi Andy,
    This is a very informative article full of great information. To be honest, I hear these expressions always here and there but the first time I understand everything about active and passive. I saved your site on my desktop inside a file called: Best online websites.
    Wishing you great success in your business
    Rania

    • Hi Rania
      Thank you for your encouraging comments. I am very glad that you enjoyed the article.
      Kind regards
      Andy

  4. Hi Andy
    I forgot to ask you in my previous comment that I passed by two terms which I could not understand, Bull market and bear market.. What do these mean?
    Another idea, if I decide to buy anything from the products you share, surely I will buy through your links.
    Have a great day
    Rania

    • Hi Rania
      I have given very brief descriptions of bull markets and bear markets in the glossary. Here are the links
      https://badinvestmentsadvice.com/glossary/bull-market/
      https://badinvestmentsadvice.com/glossary/bear-market/
      In summary a bull market is where the prices of most assets are appreciating and where most stocks break through previous levels of resistance and carry on climbing. A bear market is the reverse where the prices of most stocks are falling and breaking through levels of support and just keep declining. Bear markets often show steeper and more rapid declines than bull markets rise.
      Actually this is a simplified way of looking at markets. Markets tend to move in cycles and bull and bear markets are examples of just two phases of market movement. At other times markets are either moving sideways with varying degrees of volatility where prices move up and down between levels of support and resistance. Also in reality the market is made up of many smaller sectors which in turn are made up of sub-sectors or industries where stocks essentially are in competition with each other. Each sector and industry is its own market within the overall market. I think more on this another time. Thanks for the question.
      Kind regards
      Andy

  5. This is the sort of really useful and informational articles that I look for in a blog. I really like your way of explaining topics, and in this case, active and passive investing.
    I have a question though.
    Does active investing and active income mean the same thing? Same with passive, does passive investing mean the same as passive income?

    Thank you for sharing!
    -Joseph

    • Hi Joseph and thanks for your comment. I am very glad that you enjoyed it and found it useful. Passive investing has an accepted meaning in finance. It means just automatically mimicking the market by regularly investing in a fund that mechanically models a particular market index. With passive investing you don’t have to think but you do have to keep making money contributions. Once you have amassed a large enough sum you could just let it all sit in interest yielding bonds and enjoy the income stream which in that sense would be passive income.
      Passive income is a general term the crops up all over the internet and eBooks etc and pretty much means whatever you want it to mean. Though we all agree passive income means you would own an income generating asset that requires little or no maintenance on your part. That’s what we all hope anyway.
      Thanks for the comment and best regards
      Andy

  6. Hi Andy, there is some great information here in the different types of income. I am hoping to be earning passive income here soon too. All the very best.

    • Hi Catherine
      There are many different kinds of passive income but they usually boil down to building up, or using an existing asset that you have, or just an asset that you control – to use accounting speak – to then milk for income over time with minimal effort and preferably on auto-pilot. Most sources of passive income only become passive after a period of being actively built up and the active build up nearly always requires time, effort and persistence unless you were born with a silver spoon in your mouth or you won the lottery. So a first thing to do if you are looking for possible avenues of passive income would be to look at the assets that you already have (or control) examples could be: Your house – try BNB, your car – rent out your car when you are not using it. You could also sell your old stuff on eBay but that is going to require some work so not entirely passive. Another possible source is that if you have stock investments you can milk income by selling options but that involves some risk. Almost any business that once set up can be a source of automatic income with no effort would be a source of passive income. Here would be an ideal example. You take out mortgage loans at near zero interest, you rent out properties to responsible tenants who always pay rent on time and very cause problems and you get someone else to manage the property, paying them for it even down to arranging for any maintenance tasks needed. And it all works smoothly. Of course there is the risk that you can’t find any decent tenants, or you do but they stop paying rent etc etc. Then of course there are all the online business sources of passive income, though most of those seem to require effort to build up and I don’t yet know how much effort to maintain – I am still finding out.
      As to which would be the fastest – I could move into a tent in our yard tomorrow and put our house up on AirBNB COVID or no COVID but I think my family might object.
      Thanks for the comment and question
      Best regards
      Andy

  7. This is quite a comprehensive article – I know nothing much about investing money to be fair, but this website looks like it has the potential to be a good source of details on the rights and wrongs.

    • Hi Simon
      Thanks for your positive feedback and please to come back and check the site. I am adding material all the time. Best regards, Andy.

  8. Thank you for the article. It was interesting to see the differences between passive and active investing.
    I am planning to invest my saving is stocks and this article gave me a clearer view of how I should look into.

    Many thanks,
    Yoana

    • Hi Yoana, I am glad you liked the article and found it useful. I wish you all success with investing. Best regards, Andy

  9. Andy, another great article always educating me in the ways of finance.

    On an investment level, I would be more geared towards the passive investment hoping for long term gains and there must be some stringent rules to get out when the going got tough.

    As for a passive income, hopefully, one day and I’ll go with the Bahamas, watching the sunset drinking cocktails.

    Thank you for sharing

    Mick

    • Hi Mick and thanks for the positive comments. One of the principles of passive investing is that you stick it through thick and thin. The danger with trying to bail before the market tanks is that the chances of getting that right are very slim, also for the professionals. There are more detailed studies that look into the statistical considerations around this issue, I will get into those another time. I agree the image of watching the sunset in the Bahamas sipping cocktails has a strong appeal. One day … we can hope.
      Best regards
      Andy

  10. Hi, Andy
    Thank you for this informative and helpful post.
    It seems active investing lead to active income and passive investing leads to passive income. Or active investment is the same as active income?
    I am a full-time worker and looking to build multiple passive income streams and to retire early.
    What kind of investment can help me reach my goal? Investing in stocks? Real estate? starting an online business? I want something I can do on the side of my day job.
    Looking for your help, please.
    Thanks

    • Hi Sebastian
      The common understanding would be – active income really means getting paid to do a job.
      – passive income is getting paid after you have put the work in and then you continue to get paid.
      Active investing means making an acting on trading decisions on an ongoing basis.
      Passive investing means regular contributions into a passively managed i.e. index-linked fund.
      As to which of those investments can help you reach your goal – all of them sound like good ideas. It is really a question of what works best for you in your current circumstances as there is no one-size-fits-all answer. If you are still searching around then I would look into all of those avenues. Ask yourself what the risks and rewards are. Whether they require specific skills and whether you have the skills needed. Choose one and go for it.
      Good luck and thanks for the comment
      Andy

  11. Hi Andy,
    I really like how you explained the difference between active and passive investing as passive investing is a great option for those starting out in the financial market.

    I also enjoy how you have links to the descriptions of what you are explaining with the definitions in order to really make your articles easy to read.

    Congrats again on entering the option realm!

    Well wishes,
    Sonia

    • Hi Sonia
      Thanks and I’m glad you liked it and found it a good read. I think I will have an interesting time with options over the next weeks. I’ll let you know how it goes.
      Take care and thanks again for the comment
      Andy

  12. Hi Andy,

    This is remarkable information about a passive and active investment. I thought all investments are classified to be in passive income. I have inadequate knowledge about finance, and I learned a lot from this article.

    Thank you so much,
    Lyn

    • Hi Lyn
      Thanks for the comment. Yes you are right that income from investments that you hold is passive. The debate over passive vs active investing is more about the approach adopted to the actions of investing. I am glad you found it informative and I hope useful.
      Best regards
      Andy

  13. Both of the investments requires hard work, but I know most of us would rather have financial freedom and time freedom which we ourselves are our own boss. I know it takes some time for me personally to be successful and this is a great post for me to be aware and guided. Thanks again

    • Thanks for engaging. I am glad that you found the article interesting and I hope useful. Best regards, Andy

  14. Hi Andy,

    I must admit that I have always been drawn to the passive form of investing. I tend to view it as a long-term strategy, as in a minimum of 10 years, if not a lot longer in some cases.

    As you have mentioned, the returns you make over the long-term typically even themselves out, and can actually be quite attractive in the long-run.

    I have looked at some forms of active investing over the years (to be honest I’ve never really viewed either as “active” and “passive” before, but it makes perfect sense after reading your explanation), but the management fees always seemed a little hefty to me, based on the potential returns.

    What about yourself, do you have a preference?

    I would hazard a guess that as someone who has experience in these matters you woud have a fairly diversified investment portfolio.

    Anyway, thanks for an informative and well-structured read and keep up the great work.

    Partha

    • Hi Partha
      Like you I favor a long term passive approach and yes I make sure to always have a well diversified portfolio. I agree with you that the fees on actively managed accounts and funds can very easily wipe away any performance advantage that an actively managed fund is able to achieve. Another little secret is that many active fund managers have realized the advantage of passive investing and often put a sizable proportion of the funds they manage into passive instruments! So the poor client is paying a fee to someone to put their funds into an instrument that they could do themselves cutting out the middle man.
      Thanks for the comment and the question
      Best regards
      Andy

  15. Hi Andy,

    Your knowledge of the investment arena is truly impressive.

    Personally, my husband and I have taken the passive route over our lifetime, and though we have seen some gains, we have also seen many losses due to the many stock crashes overtime.

    Hopefully the most recent crash due to Covid will not hurt us too badly in our retirement years. We do not have the extra income to tackle active trading. Unless you’re willing to offer your services, ha ha. Just kidding!

    Thank you for another informative article,
    Suzanne

    • Hi Suzanne
      Many thanks for the positive feedback. I have also adopted a mostly passive investing approach. All the evidence suggests that consistency is the best way to ensure a positive outcome. Wishing you the best of luck.
      Kind regards
      Andy

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