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 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.) 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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