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 goal is to help you 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 investment strategies will attempt to beat index returns or accomplish other goals, such as the generation of income.
A passive investment strategy
A passive investor is concerned with tracking an index as closely as possible.
For some, the choice between the two approaches comes down to relative cost. On the whole, passively managed index funds may have lower 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 more difficult time outperforming the index. In turn, this could make low-cost passive investment strategies 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.
Professional portfolio managers may underperform against a benchmark.
|The ability to manage market volatility – active investment strategies may be better able to react to market fluctuations, which may help to reduce portfolio volatility over time
||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||Passive investment strategies tend to have lower expenses than active strategies.
||Passive investment strategies will inherently underperform their benchmarks as they include various costs (albeit not as high as active investing) such as management fees, taxes and trading costs.|
|Passive investment strategies tend to be simpler, reducing the effort required to research individual investments.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 recent past has 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 diversified investment portfolio, so long as they align with your financial goals, time horizon, tolerance for risk in your diversified investment portfolio and other personal factors.
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