Rather than make a definitive case for either method of investment, let’s instead explore the advantages and disadvantages of each approach. In doing so, the hope is that you can make an informed decision that aligns with your unique financial needs and goals.
First things first, what’s the difference between an active investment strategy and a passive investment strategy?
An active investment strategy
Active investors will attempt to beat index returns or accomplish other goals.
A passive investment strategy
A passive investor is concerned with tracking an index as closely as possible.
For many investors, the choice between the two approaches comes down to relative cost. On the whole, passively managed index funds may have low expense ratios. Conversely, actively managed funds tend to have higher expense ratios due to the fees associated with a professional portfolio manager.
In order to justify the expense of his or her fees, a portfolio manager seeks to outperform the market, and there lies the conundrum: In a climbing market, managers may have a hard time outperforming it. In turn, this could make the strong performance of low-fee passive funds more attractive.
As mentioned previously, the intent here is not to make a definitive case for active investment strategies over passive. Rather, the idea is to explore each type so you can make an informed decision on the role these strategies might play in your portfolio. With that thought in mind, let’s look at the advantages and disadvantages of each investment strategy.
|Active Investing||The possibility of beating the benchmark (i.e., outperforming the market)||Professional portfolio managers bring with them higher fees and operating expenses. This can reduce your return on investment.|
|The ability to protect against market volatility – an active manager may be able to select a portfolio well enough to help protect somewhat more than index funds against market declines||Portfolio managers need to target a return above the market average in order to justify their fees. This may expose you to additional risk.|
|Passive Investing||Passively managed index funds tend to have very low expense ratios. These low costs can mitigate the reduction of returns due to expenses.
||Passive investment strategies will inherently underperform their benchmarks as they include expenses (albeit not as high as active investing) such as management fees, taxes and trading costs.|
|Passive investment strategies tend to be simpler, as the only decision an investor needs to make is selecting a market index (i.e., the S&P 500). This frees the investor from having to research portfolio managers or individual investments.||If a particular stock experiences a run-up in price, it also typically experiences an increase in its weight within its respective index. Simply put, investors could become so over-exposed to one high performing stock that they miss out on the top performer of tomorrow or expose themselves to more risk if this company becomes significantly overvalued.|
Active management as a whole tends to outperform passive management in tough market environments. However, in periods of strong market performance it can be hard for active managers to outperform the market, making the low fees of passive investments more attractive.
It’s worth noting that volatility is a normal function of the market. While the last five years have been witness to a period of growth, you can count on the fact that market volatility will recur time and again.
When purchasing any investment, it’s important to do so with a goal or purpose in mind, while also considering the different costs and benefits inherent in it. In doing so, you may find that both active and passive investments have a place in your portfolio, so long as they align with your financial goals, time horizon, tolerance for risk and other personal factors.
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