Active vs. Passive Investing: What’s the Difference?

Written by Patrick RyanUpdated: 8th Sep 2021
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Some supposed market experts insist buying and holding for the long haul is the best approach to investing.

Others are adamant that establishing and exiting positions throughout the year is more likely to result in significant gains.

This aggressive approach to investing is referred to as active investing. Alternatively, maintaining a long-term position and employing the “buy and hold” strategy is known as passive investing. This article will explore the differences between active investing and passive investing in its entirety and will help you decide which strategy is best. 

Active vs. Passive Investing Overview

Active Investing

Active investing is ongoing trading at a relatively high frequency. In short, active investing is more centered on attempting to time the market rather than buying and holding a group of stocks for the long haul. In some cases, active investing involves entering and exiting a position within minutes, hours, or days. 

Active investing is typically focused on stocks, though it is also possible to actively trade ETFs, mutual funds, and other investment vehicles. Make no mistake, active investing is hard to do successfully. It is risky, requires deep expertise, and is not recommended for beginner investors. 

Passive Investing

Passive investing is exactly as it sounds in that investors buy and hold stocks, index funds, mutual funds, crypto, or other investments for years or even decades.

Most passive investors favor ETFs that provide exposure to the majority of an overarching index or mutual funds that diversify risk across a group of stocks or industries. Passive investing is largely associated with dollar-cost averaging and is Berkshire Hathaway’s (Warren Buffets) strategy of choice. 

Passive Investing vs. Active Investing Pros and Cons

Passive Investing

Pros:

  • Buying and holding provides a peace of mind some investors consider invaluable
  • Minimizing risk as this approach is typically centered on ETFs and mutual funds rather than individual stocks
  • Fewer trading fees and commissions 
  • Less of a time commitment than active investing
  • Relies on the stock market appreciating in value over time
  • Less taxable events

Cons:

  • Less upside as fewer trades are made
  • Fails to capitalize on opportunities that require timing the market
  • Exposure to groups of stocks in ETFs and mutual funds is not guaranteed to outpace inflation
  • If economic or political factors affect an entire industry, its respective sector ETF might significantly decline

Active Investing

Pros:

  • Greater upside as active trading capitalizes on opportunities as they arise
  • Some investors insist it is easier to handpick specific stocks rather than profit from investing in an entire sector
  • Presents the opportunity to timely pivot in response to economic, political, and other factors

Cons:

  • Heightened risk as this approach is centered on stocks rather than ETFs and mutual funds
  • More fees and commissions as the portfolio is actively managed
  • Active investing requires more of a time investment

Is Passive Investing Better than Active?

The answer to this question hinges on the investor’s specific goals and preferences.

If you are risk-averse, you will lean toward passive investing because it reduces risk with diverse exposure to an entire group of stocks, such as VOO, QQQ, or DJIA.

Passive investing also requires less time on a day-to-day basis, which is attractive to those looking for portfolio gains but have other things to do.

However, markets are dynamic. The failure to proactively take advantage of economic and current events pertaining to specific stocks has the potential to limit your investment potential.

When in doubt, consult with your financial advisor or Certified Financial Planner (such as Facet Wealth) to determine which approach to investing is optimal for your specific financial position, goals, and timeline for retirement.

Does Active Management Outperform Passive?

If you polled investors on active versus passive, most believe the active approach really does produce larger gains.

However, the data suggest that passive investing performs better than active investing, especially over the long-term.

Most investors are shocked to learn actively managed funds underperform those of the passive variety once fees are subtracted from investor gains.

Though there is the potential for short-term active investing on Robinhood (HOOD) to generate superior gains, the passive approach is more financially prudent in the context of years and decades as opposed to days and weeks. 

What’s the Difference Between Passive and Active Funds?

Active funds are actively managed with ongoing trading that attempts to capitalize on news pertaining to individual stocks, market dynamics, economic news, political news, current events, and additional developments. Examples include Cathie Wood’s suite of ARK Active ETFs.

Alternatively, passive funds are not actively managed, meaning trading is comparably infrequent. The holdings in a passive fund primarily remain the same throughout the year.

These holdings are gradually adjusted as necessary, yet the activity level is minimal compared to that of an actively managed fund.

Passive funds attempt to generate returns in line with a sector or the market as a whole while accounting for inflation.

Alternatively, active funds attempt to outpace a specific sector’s gains and the market’s overarching gains through proactive and potentially frequent trading. This means they might buy shares of Nvidia (NVDA) in the morning and sell them that afternoon.

Furthermore, these approaches are distinct in that active funds have a human fund manager while passive funds are largely automated.

However, it is important to note passive funds are not completely programmed. Humans still manage passive funds daily.

Is It Smarter for New Investors to Passively or Actively Invest?

New investors should passively invest. There will be an opportunity to transition to active investing down the line.

However, when first starting out, new investors will likely struggle to select individual stocks that appreciate.

Furthermore, paying a portfolio manager to actively manage capital with considerable exposure to individual stocks has the potential to result in short-term pain.

The better approach is to diversify the new investor’s hard-earned money across ETFs, mutual funds, some stocks, and bitcoin for ample diversification in terms of the sector as well as risk.

The investor will eventually feel comfortable making the segue to active investing as they become more experienced.

Bottom Line: Active vs. Passive Investing

Your decision to choose active or passive investing will be determined by your risk tolerance and your unique timeline for retirement.

If you struggle to sleep at night when your money is invested in comparably risky stocks, or if you plan on retiring soon, you will appreciate the merits of passive investing.

Those who are more risk-tolerant and decades away from retirement are more likely to lean toward active investing.

Investors who are still on the fence between these two approaches are encouraged to ask for guidance from a Certified Financial Planner or financial advisor.

Patrick Ryan
Patrick Ryan

Patrick Ryan is a former SimpleMoneyLyfe authority on investing and personal finance. Patrick graduated from Tulane University with degrees in sociology and political science. He also studied economics at Boston University and Tulane University and holds an ABA-approved paralegal certificate in addition to his undergraduate degrees. Patrick’s areas of expertise are investing, general financial terminology, and financial markets.