CFO of Life #45: Active vs. Passive Investing - How to decide which one is right for you?

A long time ago, when I first started investing I went into a spiral of day trading. And it was all because I thought that day trading is active investing, but how wrong I was…

I was frantically buying stocks and holding them for a few hours or days and then selling them. And all this with varied levels of success. At that time, I was thinking, "Ah, how cool and interesting it is to be an active investor".

With time, my success dwindled, and so did my confidence and my curiosity. At the same time, I started properly learning and educating myself on what investing and trading are. That made me rethink my approach towards what I do with my money and how I see investing.

But when it comes to investing, there are mainly two methods - active and passive. They both would purchase the same type of assets, but their approach and overall strategy are completely different.

Active investment is the more hands-on approach that is usually taken by any portfolio manager or another participant that constantly oversees the process of managing the money. They would be extremely involved and up to date with every move and shake of the market. That’s all with the one aim to outperform the market and provide additional returns for their investors. Even if that requires them to gaze into the metaphorical magic balls that give them predictions for hours on end.

On the other hand, a passive investor would buy stocks or bonds and hold them. It’s essentially a practice of patience and resisting the temptation to jump from one new hot stock to another. Not wanting to chase the new stock that the market is crazy about or over-index on whatever new hot sector everyone is looking at. Most of the time, this is done by simply buying an index fund and tracking the market, but more on index funds next week, now let’s focus on what strategy you should use.

So, what is right for you? Now that is a loaded question that requires us to look at a few variables. It also depends on your goal, your risk tolerance and what timeframe you have.?

Let’s look at - What is active investing?

Active investing is actively buying and selling individual stocks, bonds, commodities or any other assets aiming to beat the market.

Active investing is more risky. To beat the market consistently, you should take more risks and hopefully reap more rewards.

Active investing is more expensive. With the increased number of transactions, you would incur more fees which would decrease your returns.

Active investing can be more tax efficient, because you might be able to offset some of your capital gains taxes, but do speak to a tax advisor before attempting this.

Active investing is more time-consuming, as you need to perform substantially more research, especially when you are constantly hunting for new stocks and bonds.?

Active investing is more suitable for seasoned investors, as it has a higher barrier to entry when it comes to sophistication, portfolio management, time management and risk mitigation.

Active investing can outperform passive investing. There are plenty of active investment managers that have managed to successfully outperform the market.

Active investing is not suitable for everyone. It is important to understand all of the intricacies that come with active investing and the number of factors that have to be considered, the risk, the time commitment and the goals that you are chasing.

But on the other hand, What is passive investing?

Passive investing is buying and holding one asset or a basket of assets for a long period, without constant rebalancing of your portfolio.

Passive investing is less risky. This is true as most passive investors would just track the market and not try to outperform it.

Passive investing is less expensive. With the lower number of trades, comes the lower expense ratio as you don’t incur a lot of fees.

Passive investing can be less tax efficient. In some situations, passive investors lose the possibility of lowering their capital gains taxes, but every strategy has its trade-offs.

Passive investing is not time-consuming. Passive investing takes little to no time, and in a lot of cases can be 100% automated. All thanks to the minimum amount of time that is needed in researching the assets that you hold.

Passive investing is suitable for beginner investors. While it can be suitable for everyone, it’s best poised to help people get into the world of investing, as it has an all-around low barrier to entry.

Passive investing is more likely to outperform active investing. Most of the time, market efficiency is on the side of the passive investor, as active investors frequently fail to beat the market.

Passive investing is for everyone, regardless of who you are, what risk appetite you have, and how much experience or capital you have.

But the most important question is: What is the difference in the market returns of Active and Passive investing? As I love to say “It depends”. There is plenty of data about active and passive fund managers, but there is not enough data on active and passive retail investors (what you and I practically are).

That’s where the problem lies. If we are comparing you and me, that would be one thing, but if we compare professionals it’s a different thing entirely. That’s why I’d leave this comparison to you, so you can do some research, but I love a great debate on this topic!

With the risk of sounding like a broken record, here are all the factors that you should consider before choosing to become an active or a passive investor and how they compare between the two strategies:

1. Risk tolerance:?

Risk is a big predictor of your investment returns, as risk and reward go hand in hand. Regardless, taking too much risk will not guarantee you more reward. Taking too much risk will keep you up at night, whereas too little risk will minimise your impact in the long run, but knowing how much risk you can tolerate is extremely important.

Just ask yourself, can you stomach it if your investments are down 40% while the market is up 20%? The answer to this question will be a good guide on where you are in the passive vs. Active investing scale.

2. Investment time horizon:?

You need to know how far away into the future you are planning to invest in. Are you planning for 5 or 10 years? Or are you a 20-year-old just starting your investment journey? Well, that will be a huge factor in deciding what type of approach best suits you.

3. Your time commitment:

Active investing takes a lot of time and a lot of dedication, maybe too much if you are an extremely busy person running your own business. Well, that makes a compelling case and an easy choice in which direction you should go.

4. Investing cost:

This is a minor factor, but do you want to deal with factoring all of the investment costs, or do you like paying the lowest possible fee? This will help you make the right choice.

5. Investment knowledge:

Your level of investment sophistication is crucial to your returns and vital for the approach you take. Just take the example of my early days investing experience, if you are like me and you don’t have the knowledge, it will be close to impossible to beat the market. But if you do take the time and arm yourself with all the knowledge needed, then you would be in a better position to beat the market, but that is still not a guarantee.

Here is how you can think about the decision of which one you should adopt:

If you have plenty of time to dedicate, solid investing knowledge, a higher level of risk tolerance and a willingness to deal with the higher fees, then probably the active investing approach is for you.

At the same time, if you are time-poor, don't have a lot of investing experience or you are on the journey to do so, you have a low-risk tolerance or don't like high fees, then you should consider passive investing.

But if you are somehow in between both of them, you can always adopt a mixed approach. That combination of active and passive investing can help you offset some of your risks, allow you to gain more exposure to sectors that are experiencing current market growth or add any specific asset that you don't want to hold for the extremely long term.

Regardless of which style you choose, make sure you take your time and do your research. Understand all the risks and what the potential rewards are. Knowing that is the only way to make well-informed decisions that will help you achieve your financial goals.

Because there are pros and cons in both types of investing and there is no one-size-fits-all approach. And it is not outside of the realm of rational thinking to have a chat with a financial advisor about it, as at the end of the day they are best equipped to give you any advice about this. Don’t forget, you need to build up a strategy that not only works for you, but you are willing to commit to for the long term!

Next week, I will focus on Exchange Traded Funds or ETFs. They are a great tool that every investor should try and employ! Especially those of us that are time-poor and are just beginning our investment journey.

Thank you for reading! All comments and topic suggestions are highly appreciated. Post #45 in the series CFO of Life #si #personalfinance #CFOofLife