Investing is one of the most effective ways to build wealth over the long run, but there are so many different approaches to investing it can be hard to figure out where to start.
You can break most investing strategies down into two categories: active investing and passive investing. Both types of investors work to turn their investments into more substantial amounts of cash they can use to support their lifestyle or fund future investments.
In general, active investors monitor their investments on a daily or weekly basis, making frequent moves in and out of the market. Passive investors look for a more set-it-and-forget-it strategy, hoping that consistent investment over the long term will help them reach their goals.
Both investment strategies can work, and each has pros and cons. Knowing how each strategy works and which is right for you can help you make the most of your money.
Active investing means taking an active role in managing your money, moving in and out of different investments based on your analysis, gut feeling, or world events. Active investing can mean everything from picking individual stocks and setting buy and sell targets to day trading options.
Typically, active investors look for assets that can offer short-term profits. They often try to beat the market, earning a higher return than the market as a whole provides.
Some people like the idea of an active investing strategy but don’t want to do the work involved with active investing. These investors can work with money managers who use a proactive investing approach on their behalf.
Pro tip: If you’re planning to be an active, hands-on investor, you’ll need to open a brokerage account. There are several online brokers available. One of our favorite brokers offering free trades is Robinhood. When you sign up, you’ll also receive up to $200 in free stock. Sign up for Robinhood.
Why Do People Try Active Investing?
There are many reasons people try their hand at active investing.
One is that they want to play a bigger role in managing their money. Trusting an investment advisor can be difficult for many people, and others are simply bored by the idea of using a buy-and-hold strategy.
Others turn to active investing because they want to work to reduce their risk or increase their potential reward from investing. Active investors continuously monitor the stock market and the news, moving money in and out of investments. If something happens that could weaken the market, active investors look for safe harbors to put their money in. If they sense a business could see its share price spike, they divert funds into shares of that company. Done effectively, active investors can preserve their capital or earn large sums of money.
Active investing offers more of a challenge than buying and holding or passive investment. Some people enjoy the challenge of trying to beat the market and find it to be a more engaging way to invest.
What Do Active Investors Invest In?
Active investors use a variety of assets to execute their trading strategy.
- Stocks. Many active investors buy and sell shares in individual companies. This lets them target specific businesses they think will perform better than the average in the near future.
- Bonds. Some active investors trade in bonds issued by governments and businesses. If market interest rates fall, bond prices tend to increase, giving active investors a way to profit off changes in the rate market. Active investors might also strengthen their position in bonds if they fear a bear market in which stock prices decrease.
- Options. Options allow active traders to make bets on changes in a stock’s price. Options traders buy and sell the right to buy or sell shares at a set price up to a fixed future date. Options let investors leverage their investments, giving them the chance to make massive amounts but also to lose so much they wind up with a negative balance. That makes them suitable only for experienced investors who are willing to take risks.
- Exchange-Traded Funds. Exchange-traded funds (ETFs) are like mutual funds in that they let investors buy and sell shares in multiple businesses while only dealing with a single fund. Unlike mutual funds, you can buy and sell ETF shares throughout the day, making them more suitable for active traders. Many ETFs track market indexes or industries, letting investors make bets on specific areas of the market. Some use leverage, so their prices experience double or triple the change in an index’s value, letting traders go all-in on their bets. Like mutual funds, ETFs charge management fees that can eat away at active traders’ gains.
- Commodities. Some active investors choose to trade in commodities like oil, corn, natural gas, or wheat. Commodities let active investors speculate on future price trends and can serve as a hedge against inflation.
Pros & Cons of Active Investing
Active investing has both benefits and drawbacks you need to keep in mind.
- Greater Potential Reward. Active investors’ main goal is to beat the stock market. That means making more money when the market is good and losing less money — or even continuing to make money — when the market does poorly. Good active investors stand to make a lot of money, but active investors who don’t do well will likely lose more than a passive investor.
- Greater Flexibility. Whether you manage your money yourself or work with an active money manager, active investing offers more flexibility than passive investing. You can move money in and out of specific economic sectors or investment types based on the financial atmosphere. Passive investors almost always try to stay the course with their chosen investments.
- More Investment Options. The majority of passive investors use just a few investment vehicles, such as mutual funds or ETFs. Active traders can find a place for things like individual stocks, options, and commodities in their portfolio, allowing them to execute more sophisticated strategies.
- Greater Potential Risk. Active investors expose themselves to higher levels of risk than passive investors, offsetting their higher potential rewards. Imagine a scenario where an active investor sells his stocks right before the start of a bull market or buys into an investment right before it crashes. This investor stands to miss huge gains or see their savings wiped out. Passive investors don’t face a similar risk.
- Higher Costs. Active investing strategies tend to cost more than passive ones. Most active investment managers charge a fee based on a percentage of your assets. Even if you manage your portfolio yourself, you’ll have to pay more brokerage fees as you move money in and out of the market.
- More Effort. Active investing takes much more work than passive investing. You need to keep track of economic, business, and market news and dedicate time to researching investment options. This takes time you could devote to leisure, family time, self-improvement, earning more money at work, or other activities. There’s also no guarantee the effort you put in will bear fruit.
Passive investors tend to avoid trying to beat the market. Instead, they prefer an easy-to-manage strategy where they make a single investment and let it ride. Instead of frequently trading in and out of positions, they make occasional changes to their asset allocation or to rebalance their portfolio.
Passive investors usually try to track a specific market index or to match the performance of the total market. Typically, passive investors worry more about their long-term gains than short-term profits.
People who choose a passive investing strategy can manage their own portfolio or work with a low-cost investment advisor who uses buy and hold strategies.
Why Do People Try Passive Investing?
Many people prefer passive investing for several reasons.
One is that passive investing is much easier than active investing. Passive investments require maintenance in the form of rebalancing your portfolio, but usually only once every few months. You might occasionally decide to change your asset allocation, but only after a lot of consideration.
Another reason is that some people think passive investing is more effective than active investing. Timing the market is incredibly difficult, and most people see better performance through passive than active investing.
Pro tip: Using a robo-advisor is a great way to passively invest. You can set up automatic investments and it will automatically rebalance your portfolio based on your risk profile. One of our favorite robo-advisors is SoFi Invest.
What Do Passive Investors Invest In?
Most passive investors use the following investments to build their portfolios.
- Mutual Funds. Mutual funds hold a wide variety of stocks and bonds, making it easy for investors to diversify their portfolio while only buying shares in one fund. Many passive investors focus on index funds, which track a market index like the S&P 500 or the stock market as a whole. Index funds tend to be extremely inexpensive, and most major brokerage companies and retirement plans offer them.
- ETFs. ETFs are like mutual funds, except investors can trade them on the market during trading hours rather than waiting until the end of the day for the fund manager to complete buy and sell transactions. This makes them slightly more liquid than mutual funds. Some ETFs also have lower expense ratios than their mutual fund counterparts, making them the cheaper option.
- Stocks. Some passive investors like to pick individual companies to invest in for the long term. For example, a passive investor might buy shares in blue-chip stocks and plan to hold them for the long term.
- Bonds. Passive investors can also select individual bonds or bond funds to purchase. These can include U.S. or foreign government bonds or bonds issued by corporations or municipalities.
Pros & Cons of Passive Investing
Passive investing brings its own host of pros and cons.
- Easier. Active investors need to keep up with business and market news and devote time each day or each week to making trades in their portfolio. Instead of spending hours a week on their portfolio, passive investors can spend just a few hours per year maintaining their investments.
- Less Risk. Active investors face the risk of selling their investments at the wrong time or buying in when the market is at a peak. Passive investors buy investments and hold them. They won’t have to worry about buying or selling at the wrong time and can rely on steady market growth over the long term.
- Less Expensive. Passive investors don’t have to worry about all of the transaction fees active traders pay. Instead, they can park their money in index funds that typically charge fees of 0.10% or less. Even passive investors who work with an investment manager usually pay fewer fees than those who work with active investment managers.
- Lower Potential Rewards. Passive investors tend to focus on tracking the market over beating the market. A skilled investor who makes regular trades can outpace the market’s gains and make a lot of money. Passive investors typically realize average gains in line with the broader market’s performance, but no more.
- Doesn’t Protect Your Funds From Short-Term Drops. Passive investors don’t try to sell out of their positions before stocks drop in value; they’re typically content to ride out the market’s ups and downs. Sometimes, though, the market does poorly because of prolonged economic conditions like a recession. If you need to sell investments to cover your normal living expenses, you could be forced to sell when prices are low, potentially at a loss. Active traders work to avoid that situation, creating cash reserves by selling when the market begins to perform poorly. The passive approach to investing can be especially hard to maintain when economic news is bleak, prices are falling as active investors bail out, and the urge to “do something” mounts. But the worst thing a passive investor can do is to sabotage years of gains by panic selling after the market has already dropped.
Active vs. Passive: Which Investing Strategy Is Right for You?
The correct choice of investing strategy relies on your investing goals, interest, risk tolerance, and willingness to spend time working on your portfolio. To choose your investing strategy, ask yourself the following questions.
- Do You Want to Spend Time Following Business and Economic News? People who don’t have the inclination or time to devote to following the news should probably stick to passive investing.
- Are You Willing to Spend an Hour or More Each Week Making Trades? If day trading or just looking at your portfolio regularly sounds fun, then active investing might be a good fit for you. If you don’t want to spend that much time on your money, stick to passive investing.
- Can You Accept the Risk That Your Trades Turn Out Poorly? People who invest in index funds can feel relatively confident the market will bounce back. If you’re an active trader, you might buy stock in a business that goes under or have an options trade wipe out your portfolio.
- Do You Have a Short or Long Time Horizon? People looking for short-term gains can make more money from active trading if things turn out well. A passive strategy may better serve long-term investors.
For most people, a passive investing strategy is probably the best choice. Beating the market — the primary goal of most active traders — is incredibly tricky. In the 15 years ending in 2019, almost 92% of actively managed mutual funds failed to beat the returns of the S&P 500. That means only 8 out of every 100 professional money managers can do better through active investing than through passive index investing.
If you’re one of the 8% who can beat the market over the long term, then you can make a lot of money through active trading. You might even want to consider working in money management. But in reality, very few people can pull it off.
There are many ways to invest. Some take an active hand; others focus on buying and holding the same securities for the long term. Most people are probably better off with passive investing, but there’s nothing wrong with designating a portion of your portfolio for experimenting and having fun with active trading.
As always, work with a financial advisor if you’re unsure about how to manage your money best. They can help you design and execute a plan that will help you meet your financial goals.