When investing, people often wonder what is the best strategy(active or passive investment)?
First, Active investing is buying and selling investments based on research or a set trigger. Active investors try to outperform the index they are tracking, like the S&P 500 index, which is made up of the largest publicly traded companies. Active investors hope their superior knowledge of the company or market conditions will allow them some form of edge over the rest of the investing world.
Passive investors on the other hand, do not care about trying to outperform an index. They just buy and hold. Perhaps they buy an index mutual fund or Exchange Traded Fund (ETF) that tracks the entire index, like the S&P 500 or the Nasdaq 100. Passive investors do not have to be on their computers all day long tracking a particular investment. They let the markets take care of themselves
There are pros and con’s to both active and passive investing. Active investing can allow an investor to use advanced trading strategies such as hedging or option trading. Active investing can also allow more tax management. For example, when you buy and index mutual fund, you do not get to control the capital gains or distributions from the fund. This can have significant impacts for people in high tax brackets. With active management, you can control when and how to sell something in your portfolio and take advantage of tax harvesting strategies. Besides the time and effort involved in active investing, another downside can be the cost. Custodians often charge trading fees and when you actively manage a portfolio you need to take those costs into the calculation.
Passive investing does allow someone to “set and go”. They do not have to track every investment daily. The costs also tend to be lower. However, as mentioned, you may not be able to control the tax management as effectively. An index mutual fund or ETF may have a distribution that needs to be reported on your tax return.
Another pitfall to active investing is your emotions. Watching the markets all day can cause someone to get too caught up in whatever trend is happening. Think of lemmings rushing off a cliff. If everyone is stampeding towards the door, should you be following? And of course, the television news shows are designed to keep you actively watching. I call is “Financial Porn”. They don’t want you to avert your eyes for a moment because they make money selling ad space and the more eyeballs watching, the more money they make.
What is interesting is that active investing generally does not significantly outperform passive investing. Study after study has show that it is very difficult for most to outperform an index when all things are equal. And the extra costs involved in active investing can be a high hurdle to overcome.
Deciding which strategy to use will come down to your feelings and capabilities towards investing, how much time you want to put towards your investments and your tax situation.
If you work with a financial advisor, you should discuss these strategies and how they best fit into your overall financial plan.