Active Investing vs. Passive Investing: Have the Best of Both

We make several choices each day. From attires to food, vacations to education, or jobs and cities. While some of these are minor decisions which may not have a significant financial implication, others go a long way in shaping up our personal finances.

For instance, choosing to study domestically as compared to overseas with a loan could turn out to be rewarding in the long run even with a relatively lower salary given the benefit of lower debt and cost of living. And yet, for someone who wants to settle outside the country in the long run, an overseas education, even if bank-funded, may turn out to be a better option.

The journey of investing is similar. 

While there are general guidelines as to how one should approach the process of investing, the choices made by each individual must be something that suits their goals, and as such, there are generally no uniform solutions to suit everyone.
 

The decision to follow a certain style of investing is determined by several factors which include risk tolerance levels, liabilities and responsibilities, goals, time frame available, domain knowledge etc. Which means that something which is suitable for one person, may not be for another.

Let’s discuss two styles of investing today - active and passive - what they mean, the pros and cons of each style and why one should opt for a certain method of investing.

Active Investing 

• Like the name suggests, this method of investing implies a hands-on approach to managing money, with the idea that returns made using this style of investing will beat the returns of an underlying or benchmark index.
• It typically entails the participant being much more active in the day-to-day management of their portfolio, including tactical management, which means trying to make the best in any given situation, typically by taking positions for the short term.
• This means that irrespective of whether the market is in an upward or downward momentum, an investor following this strategy will try and take a position in a manner where they can benefit from the situation. 
• Because of the higher number of transactions involved, the turnover of an active investor tends to be higher than that of a passive investor.
   

What are the benefits?

Flexibility

• Whether it is managed by an individual who has the bandwidth or resources to do so, or in the hands of a portfolio manager, an actively managed portfolio offers higher flexibility as the one managing the funds can choose to tweak allocation as per their view. For instance, if an investor is extremely bullish on the technology space, they can make it as much as 50% of their portfolio, something that a passively managed portfolio would not usually have.    

Tactical Allocation

• An active management of a portfolio allows for both buying and selling of securities depending on market conditions, which can help investors make profits.

Prospects of outperforming 

• While passive investing is bound to mimic the performance of the underlying or a benchmark, an active management of the portfolio has prospects of outperformance.
   

What are the drawbacks?

Higher Costs

• Because of the higher number of transactions involved, the cost of actively managing a portfolio is higher than a passively managed portfolio.
   

Errors

• Given the human involvement in actively managing a portfolio, it is also prone to these risks, and may not necessarily beat the benchmark taken into consideration.

Passive Investing 

• A passive style of investing aims to build a portfolio for the long run, typically by investing in index funds. 
• The idea of these funds is to keep transactions and a churn in the portfolio minimal, with a focus on selecting and holding stocks for the long run.
• Given that most indices exclude underperforming constituents after a period of time, an index automatically adjusts to have relatively better performing constituents, and as a result, an investor’s portfolio also reflects these changes.
• Institutional investors are among the largest followers of a passive style of investing, as are those who are looking to invest with a long time horizon.
• A passive style of investing can be useful for goals such as retirement planning.
   

What are the benefits?

Lower costs

• This is perhaps the biggest advantage of a passive style of investment. Cost savings come not just from lower fund management fees, but also a lower turnover and churn in the portfolio. Ultimately, these cost savings also add to the returns of the portfolio.

Suitable for all

• For those who may not have a deep understanding of the securities and equities market, a passive style of investing is suitable as it does not need a high level of involvement on a daily basis.
   

Steady returns

• The returns made in a passive style of investment will generally be more steady as compared to an actively managed portfolio.
   

What are the drawbacks?

No customisation

• A passively managed portfolio does not allow for making changes as per one’s understanding and opinion of a particular sector or security.

Cannot beat benchmarks

• Because they are meant to only mimic certain portfolios, these funds do not offer investors the chance to outperform the underlying or the benchmark.

Conclusion

Whether one should opt for an active style of investing or passive can only be determined by their goals, risk appetite and understanding of the capital market. Depending on one’s requirement, both can be beneficial, and investors must take their call accordingly. 

An investor may also opt for a mix of both active and passive strategies. This balanced approach allows them to benefit from professional advice for a portion of their wealth, while maintaining control over the rest of their investments. By doing so, they can enjoy the flexibility and potential for higher returns that active investing offers, while also ensuring the stability and cost-efficiency associated with passive investing. This combination can help diversify risk, as one part of the portfolio can be tactically managed for short-term opportunities, while the other focuses on long-term growth, providing a more well-rounded investment strategy.