Active vs Passive Investing: How Choosing Became Harder for 2023
Investing is a crucial part of building wealth, and it has never been easier to do so. With technology, you can invest in just a few clicks of a button, and with the rise of index funds and ETFs, the barrier to entry for investing in the stock market has lowered significantly.
In this blog post, we’ll discuss the differences between active and passive investing, how to choose between the two, and the challenges that come with each.
Active Investing
Active investing is an investment strategy that aims to outperform the market by selecting individual stocks or other securities. This approach requires some research and analysis on behalf of investors. Or, if investors want to engage the services of an investment manager, it requires a high degree of trust.
Advantages of Active Investing
One of the primary advantages of active investing is the potential for higher returns. This potential can be quite alluring to investors unsatisfied with achieving average rates of return. The mere possibility of achieving higher rates of return is often enough to entice many investors to actively manage their portfolio or to employ someone who does.
Disadvantages of Active Investing
Active investing comes with higher fees, as investors must pay for the expertise of fund managers and analysts. Additionally, the time and effort required for research and analysis may not be feasible for many investors. Finally, it is statistically impossible to identify skilled managers who can consistently outperform the market.
Passive Investing
Passive investing is an investment strategy that seeks to match the performance of a broad market index or benchmark. This approach involves investing in index funds or ETFs that track a specific index, such as the S&P 500. Passive investors typically rely on asset allocation decisions to achieve their investment objectives.
Advantages of Passive Investing
Passive investing has gained popularity due to its low fees and ease of use. Investors can gain exposure to a diversified portfolio of stocks at a fraction of the cost of actively managed funds. Additionally, passive investing requires minimal time and effort, making it a popular choice for many.
Disadvantages of Passive Investing
Passive investing comes with lower potential returns compared to active investing. Investors are limited to the performance of the index, and there is no opportunity to outperform the market. Additionally, investors have no control over the specific companies included in the index, only which indexes to choose.
The Rise of Index Funds and Passive Investing
By the 1960s, advancements in computer technology allowed academics to show how most money managers performed compared to the US stock market. The conclusion, famously articulated by Burton Malkiel in his 1973 book A Random Walk Down Wall Street, was that a blindfolded monkey throwing darts at the stock listings could do as well as professionals. This led to the development of index funds at firms like Vanguard Group Inc., which offer “average” returns by buying a broad swath of the market while charging lower fees.
Passive Investing Takes Over as Stock Picking Fails
Data from S&P Global shows that fewer than 15% of active US large-cap funds beat the market in the long-run. Meanwhile, fees for passive funds are significantly lower than those for actively managed mutual funds. The rise of passive investing over the last decade can be attributed to the wide availability of index funds, their low cost, and their superior performance.
Investment Returns During 2022 Are Fueling Debate Over Active vs. Passive Investing
Active managers have argued that the period after 2008 was abnormal, and indexing would not perform well when markets became more volatile. The investment returns of 2022 have shown that 62% of active large-company funds beat the market, which is the highest percentage since 2005. However, the question remains whether this is a sustained trend or a blip and whether it’s enough to save active management.
What Impact Do Cash Holdings Have on Relative Returns?
Active managers say that their relative outperformance during 2022 proves their worth. But, the outperformance of active managers during times when the stock market falls can also be attributed to their cash position.
Active managers typically hold some cash in their portfolios, while index funds do not. This means that during market downturns, active managers are helped by their cash cushion, while index funds are fully invested and take the full weight of falling stock values. Conversely, the same cash position that cushions active managers during market downturns is also a drag on their returns while markets are rising. This fact is a key reason for the underperformance of active managers most years.
The bottom line is that the outperformance of active managers during bear markets can be attributed to holding some cash rather than to their skills.
Choosing Between Active and Passive Investing
Choosing between active and passive investing ultimately comes down to individual preferences and goals. Active investing may be more suitable for investors who truly enjoy picking stocks. Passive investing may be a better fit for those who prefer a low-cost, low-maintenance investment strategy, with more predictable results.
The Challenges of Choosing
Choosing between active and passive investing can be challenging, and there is no right or wrong answer. Both approaches have their advantages and disadvantages, and the best choice will depend on personal preferences and investment goals. Additionally, the investment landscape is continually changing, with new products and strategies emerging, making it even more challenging to make informed decisions.
Conclusion
Investing can be a daunting task, but with the rise of technology and the proliferation of investment options, it has never been easier to start. Active and passive investing are two popular investment strategies, each with its pros and cons. Choosing between the two can be challenging but understanding the differences and considering personal preferences and goals can help make informed decisions. Ultimately, investing is a long-term game, and it’s essential to remain disciplined and committed to the chosen strategy.