English
In the context of investing in securities, there are really two distinct approaches to managing investments: passive investing and active investing.
While both of these approaches seek to maximize shareholder value and achieve return on investment and they pretty much utilize the similar assets, each of these comes with its own distinct strategies, goals, advantages and disadvantages, and risk profiles.
Understanding the difference between the two could be crucial in analyzing and deciding which approach works best for you.
As the name suggest, passive investing is an approach whereby the investor looks to minimize the amount of buying and selling involved and transactions.
It is largely hands-off approach that favors a long-term strategy by adopting a buy and hold approach with the aim of building wealth over a long period of time. Unlike with active investing, the aim is to match the market indices that are followed rather than outperform it.
Among the most commonly-used tools in passive investing is buying into an exchange-traded fund that tracks the performance of a particular index – regardless of the type of asset class that index tracks (stocks, bonds, real estate, derivatives, etc).
An investor essentially buys a stake in an ETF That funding will then be distributed to each component in the index proportionate to that component’s weight.
Mutual funds are also a common tool used in passive investing. Mutual funds pool investments from many people – who buy shares in the fund – and investment them in a variety of different asset classes.
Read more about: Index Funds, Mutual Funds and ETFs, What are the differences?
Passive investing requires very little time commitment on the part of the investor, as they not only spend less time trading, but also spend less time researching each individual component.
It also takes less effort to manage a portfolio as it is a hands-off strategy. It is also less risky than active investing, as the investment is highly diversified, with the only real risk being market risk.
And since it involves less transactions and less trades, it also incurs less costs in fees, and less capital gains taxes.
There are really two major disadvantages to passive investing: First, it only seeks to match the market and not outperform it, so an investor may see less returns than with active investing.
The second, is that it offers very little flexibility as investors cannot make tactical moves in response to market conditions and opportunities.
Active investing is pretty much the opposite approach, relying on frequent and active trades in specific securities and instruments with the goal of outperforming the market.
It is very much a hands-on approach that hopes to see returns from short-term positions and capitalize on short-term trends in the market by actively buying in and then out of securities.
Active investing relies on picking individual securities that can outperform the market. This involves analyzing an individual security like a stock, including looking at past performance, researching the company’s financial and operational performance, reading up on daily news that could impact the performance of the stock.
Active investing also looks to capitalize on market trends and so would probably involve a lot of technical analysis, and studying seasonal as well as intraday fluctuations in the market as well as researching and reading news that could impact it.
Th main advantage of active investing is the potential for higher returns when compared to passive investing, as the goal and objective is to outperform the market through smart decision making and market timing.
It also affords the investor much higher flexibility, as active investors can adapt and shift their trades in response to market behavior and fluctuations.
As the name suggests, it requires the investor to take a proactive approach by studying a potential investment and then making frequent trades.
This requires not only a lot of effort and consumes a lot of time, but it also requires a certain degree of competency and ability to analyze stocks and read the market. Active investing is also more costly, as it involves frequent transactions and trades, incurring more fees as well as greater capital gains taxes.
It is also potentially riskier as it is very difficult for active investors to consistently beat the market.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
