Passive vs Active – How your approach to investing could determine your success

15 Aug 2023

Investing in financial markets is often perceived as a sophisticated process, involving a myriad of strategies and choices.

One of the key choices an investor must make is whether to adopt an active or a passive investment approach.

Both strategies have their merits and potential drawbacks. Understanding the fundamental differences between them can significantly impact your investment outcomes and success.

Active investing: seeking outperformance

Active investing is a hands-on approach that is often best left to professionals and one that is often employed by the managers of funds on which many regular investment products are based.

It involves selecting individual stocks, bonds or other assets in an attempt to outperform the market. This strategy typically relies on an investment manager or a team of analysts who use their expertise to research and analyse various investment options.

The goal of active investing is to beat a particular benchmark, such as the S&P 500 or FTSE 100, rather than merely matching its performance.

Active fund managers use a range of tactics including market timing (buying or selling based on predictions of market movements) and sector rotation (moving investments around different sectors based on their expected performance).

However, this approach comes with higher costs due to frequent trading and research expenses, which can eat into the investment returns.

Furthermore, despite the diligent efforts of fund managers, not all active funds consistently outperform their benchmarks.

Passive investing: matching the market

On the other end of the spectrum lies passive investing, a strategy that aims to match, not beat, the performance of a specific market index.

This approach involves investing in an index fund or exchange-traded fund (ETF) that replicates the holdings of an index, such as the S&P 500.

The belief is that over time, the markets will generate a positive return, and by mirroring the market, an investor will share in these returns.

Passive investing requires less management compared to active investing, which results in lower costs.

This lower cost is one of the primary advantages of passive investing and is a key reason why some passive funds have been able to outperform their active counterparts, particularly after fees.

However, by design, passive investors give up the possibility of outperforming the market as they are only aiming to replicate the market’s performance.

Choosing your approach: passive, active, or a blend of both

So, which approach is better? The answer largely depends on an investor’s individual circumstances, including risk tolerance, wider investment portfolio, and financial goals.

Active investing may suit investors who are willing to take on more risk for potentially higher returns and do not mind paying higher fees for the possibility of outperformance.

On the other hand, passive investing can be a good fit for those who prefer lower costs, are comfortable with market-level returns, and prefer a less hands-on approach to their investments.

Some investors may even opt for a blend of both strategies, allocating a portion of their portfolio to active investments for potential outperformance, and another portion to passive investments for diversification and lower costs.

Any investment comes with considerable risk and requires careful consideration and independent professional advice.