Active vs. Passive Investing

by Jon Dulin

passive investingWhen it comes to investing, I embrace buy-and-hold investing with mutual funds, also known as passive investing. You may be asking what exactly is passive investing and how does it differ from active investing? Or better yet, what is active investing? Well, I’m glad you asked. This post is going to walk you through both types of investing and show you why if you want to be a successful investor, passive investing should be your choice.

Passive Investing & Active Investing Defined

Passive Investing: Passive investing involves purchasing investments with the intention of long-term appreciation.

Active Investing: Active investing involves ongoing buying and selling actions by an investor. Active investors purchase investments and continuously monitor their activity in order to exploit profitable conditions.

After reading that, you may still be wondering what the difference is between the two. In a nutshell, passive investing involves buying and holding an investment while active investing involves more frequent buying and selling to take advantage of conditions.

Those on Wall Street are trying to sell you active management. They claim that in return for paying a higher management fee, you will earn higher returns. Sadly, research has shown that this is not the case. In fact, roughly 80% of actively managed mutual funds fail to beat the market. Why is this? There are a few reasons, two of which are:

Investment Choices

Active fund managers are buying and selling constantly, trying to earn a higher return than the market. No one knows which stocks will rise in value or fall in value over time. No one. You may think that because the fund manager does this as their career and has advanced degrees, they will be able to tell what stocks will do. But they cannot. They can use their best judgment, but at the end of the day, it’s just their best guess.

Consistently Earn Higher Return

In order to beat the market, the fund manager has to earn a higher return than the benchmark they are up against. But this does not mean if the benchmark returned 8% and the fund returned 8.1% the fund beat the market. Since actively managed funds charge a higher expense ratio (fee), they have to return a higher percent compared to the market. If the fund has a 1% fee, the fund has to beat the market by more than 1% in order to beat the market. This may not seem like a lot, but it is not easily accomplished.

The Solution?

Invest in passively managed mutual funds or ETFs that track the market. It isn’t sexy or glamorous. It’s investing. Invest your money in a handful of well run passive mutual funds, add money on a regular basis and forget about them. (Read here for things to look for in mutual funds, then consider investing with a firm like TradeKing.)

Ignore the media and the doom and gloom when the markets drop. Ignore the hype when your mechanic tells you of a fund that he earned 50% in last year. Simply invest in the market and earn the market return. It sounds easy and it is. The hard part is ignoring your emotions and acting on them.

If you want to learn the basics when it comes to investing and be a successful investor, I suggest you read my eBook, 7 Investing Steps That Will Make You Wealthy.

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Jon Dulin

Hi, my name is Jon and I run Penny Thots. I blog about many personal finance topics, but my specialties lie in investing, paying off debt and career goals. I also blog at Money Smart Guides.
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{ 17 comments… read them below or add one }

Helen A. April 17, 2012 at 9:47 am

I am definitely a passive investor. Originally not by choice, but because I didnt know enough about investing to be an active investor. But now that I have read your post and understand the difference, I will remain a passive investor beacuse of the things you shared and because it has always worked well for me. Thanks for the great post! I will be checking back often!

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admin April 17, 2012 at 10:17 am

There is a lot to be said for passive investing. The results are good and the time commitment is minimal.

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Poor to Rich a Day at a Time April 17, 2012 at 11:27 am

Loved this post, very informative, thanks for sharing!
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BusyExecutiveMoneyBlog April 17, 2012 at 9:43 pm

I am also a passive investor. If professional active guys underperform the vast majority of the time, I see no reasonable way I can do better. In actuality, passive, index investing will outperform the majority of the active guys every year. I’ll take that
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admin April 18, 2012 at 7:29 am

Makes perfect sense BEM.

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MoneySmartGuides April 18, 2012 at 9:53 pm

That’s the funny thing. Active managers rarely beat the market on a consistent basis, yet so many people still invest in those funds. My guess is because most investors simply look at the return of the fund in question and not the index, or just read an article about a ‘hot’ stock and buy in because it is ‘hot’.
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Jeanne April 17, 2012 at 9:51 pm

I learned this the hard way. I was with an advisor who preached active management, and in a 2 year period, I didn’t really see any benefits. I have since changed advisors and the passive approach seems to be a better long term strategy.

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admin April 18, 2012 at 7:29 am

Sounds like you have learned a good personal finance lesson.

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Jon Dulin April 15, 2014 at 7:57 pm

When I first began investing, I bought into the active management style myself. I think most of us do since it’s so glamorous to think we can earn a higher return. Sadly, it rarely turns out that way.

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Elaine Colliar April 18, 2012 at 8:58 am

I figure the only people getting rich on “active investing” are those who get paid when you trade. Far easier on the blood pressure to buy well and hold long term.

Good common sense advice though.
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MoneySmartGuides April 18, 2012 at 9:55 pm

Investing for the long-term is easiest when you ignore the media with their hype regarding the market over the short-term. Prepare a plan that will help you meet your goals and stick to it!
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Nick April 25, 2012 at 1:12 pm

Who needs sexy!?!? I’ll take the returns… I once ran the numbers and if it takes you 4 hours per week to beat the market by 2% (not easily accomplished) on a 50,000 portfolio then you’re making less than $5 per hour for your time (before taxes!).

I’ll take passive investing for the vast majority of my $$. I have a few bucks that I play with but just a few and money I’m fully prepared to lose.
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MoneySmartGuides April 26, 2012 at 12:24 pm

My time is worth much more than $5!

I too have an account with play money. I still don’t devote much time to it and am OK with losing all of it. Luckily though that hasn’t happened yet!
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Money Infant April 26, 2012 at 10:15 am

Simple index ETF’s FTW. Matches the index they are tied to, ultra low expenses and no need to worry about a trader blowing up the account.
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MoneySmartGuides May 1, 2012 at 7:57 pm

Love it!!
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Kyle Gisborne July 3, 2012 at 2:15 am

I like passive investing because active management can’t beat passive consistently anyway. Most of my mutual funds and ETFs are passive index. My dividend portfolio are comprised of individual stocks and I’m mostly inactive there as well.

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admin July 5, 2012 at 7:02 am

It sounds like you know what you are doing.

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