When investing in the stock market, there are two high-level approaches that most investors choose between: active and passive. While both methods work, one has been much more successful than the other.
And you might be surprised at which one will likely make you richer.
Active vs. Passive Investing: The Pros and Cons
What’s the difference between active and passive investing?
Active investors frequently buy and sell stocks, bonds, and other securities to try to outperform the market. Active investors typically follow a specific investment strategy and make trades based on their research and analysis. The goal is to generate returns that are higher than the market average.
On the other hand, passive investors are much more hands-off and invest in index funds and ETFs (rather than picking and choosing individual stocks) designed to track market indexes, such as the S&P 500. The goal of passive investing is to match the overall market's performance rather than trying to beat it.
Both strategies can work. According to the numbers, however, one of these strategies works much better than the other and requires substantially less effort.
But before we get there, let’s discuss the pros and cons of both investment approaches.
Active Investing Pros:
Opportunity for higher returns: The potential for higher returns is the primary advantage of active investing. Experienced active investors can use their knowledge and expertise to identify undervalued securities or companies with high growth potential, resulting in higher returns.
Flexibility: Active investing allows for more decision-making flexibility than passive investing. Active investors can quickly change their portfolios to capitalize on market conditions, unlike passive investors, who typically make fewer trades and are less flexible.
Active investors avoid risky securities: They can use their judgment to avoid risky investments, such as companies with weak financials or questionable business practices. This can help them avoid significant losses.
Active Investing Cons:
Higher fees: Active investing typically involves higher fees compared to passive investing. Active investors must pay for research, analysis, and transaction costs with every buy and sell, which can eat into returns.
Much higher risk: Many active investors underperform the market despite their efforts. According to a study by S&P Dow Jones Indices, over 85% of active fund managers underperformed their benchmarks over a 10-year period.
Emotional biases: Active investing requires a lot of discipline and can be influenced by emotional biases, such as fear or greed, leading to poor investment decisions.
Passive Investing Pros:
Lower fees: Passive investing typically has lower fees than active investing because this strategy involves less buying and selling. Since passive funds do not require extensive research and analysis, they can pass on savings to investors through lower fees.
Diversification: Passive investors have exposure to a wide range of securities, which reduces the risk of a single company or sector impacting their portfolio.
No emotional biases: Passive investing does not require frequent trading or decision-making, reducing the impact of emotional biases on investment decisions and subsequent returns.
Passive Investing Cons:
Limited returns: Passive investing aims to match the market returns, which means investors are unlikely to outperform the market.
Less customization: Passive investors cannot customize their portfolios to reflect their individual investment goals or strategies.
Exposure to overvalued or risky securities: Passive investing can result in exposure to overvalued or risky securities, as the portfolio simply tracks the market index.
Active vs. Passive Investing: Which One Wins?
In a battle between active and passive investing, which will make you rich?
You might expect an active approach designed to beat the market and achieve higher returns to be the money-maker.
But you would be wrong.
CNBC called active investing returns “abysmal.” In fact, most studies find that over 80% of active investors underperform the S&P 500 index and passive investment strategies.
Passive investors make more money than active investors for a variety of reasons:
Active investors pay more fees for research, trading, and management, which eat into returns over time (we discussed this in the pros and cons section above). On the contrary, passive investors typically invest in low-cost index funds or exchange-traded funds (ETFs) with lower fees and expenses.
Secondly, active investors face the challenge of consistently outperforming the market, which has proven impossible over the long term. While some active managers outperform the market in certain periods, studies have consistently shown that very few are able to do so over the long term (think decades).
Finally, passive investing allows investors to benefit from the market's long-term growth potential without relying on the performance of individual stocks or actively managed funds. This approach can help investors avoid the risks associated with concentrated portfolios, market timing, and other active investment strategies.
And one more benefit to passive investing: You also get to spend more time with your family because you’re not diving through financial statements, worrying about price-to-earnings ratios, or tracking any other mind-numbingly dull financial benchmark for hundreds of companies.
Ultimately, passive investing will make most people richer than active investing.
Index and forget.
This post originally appeared on Wealth of Geeks.