Nov 09, 2017

Active vs Passive Investment Strategies - What's the Difference?

By Byron Ellis

How to manage an investment portfolio is a matter of personal preference and opinion. Deciding between passive and active management greatly depends on several factors. This includes: the type of risk a person is willing to take, the type of portfolio they hope to build, and the returns they hope to see. However, the first step in making a decision is understanding the differences between the two methods of investment management.

Actively Managed Investments

Active management appears to currently be the most popular form of investing. Active managers seek to find the best deals in the market and add return or risk reduction based on their decision making. To do this they use a variety of methods, including fundamental, technical, and macroeconomics analysis. This analysis helps them create an investment strategy based on trends in the market and economy. Active managers also take into consideration the health and value of specific companies.

The idea behind this method of investing is that the market is not efficient. Therefore, it can be exploited to render better than average returns. Active managers are constantly searching for new information and trends. As a result, they can build exceptional skill and experience that helps them to identify the best investment opportunities currently available. Their close watch on the market also affords them the chance to utilize defensive techniques that reduce negative impact on a portfolio.

Active management can be considered a more risky form of investing than passive management. The portfolio can carry fewer securities and a model or humans are making trading decisions about where to place the money within the market. As a result, when the manager is wrong, they often significantly under-perform in the market. On the other hand, when they are right, they often gain better than average returns.

Passively Managed Investments

Passive management has long been preferred over active management by institutional investors like college endowments or pension funds. However, for individuals it is still relatively new. Passive managers do not attempt to forecast prices, and generally invest broadly in sectors of the market known as indexes. Decisions with this method of investing are made by analyzing long-term market data. The goal is not to outperform the market, but to duplicate the performance of a specific index.

Passive management holds to the belief that the market is efficient, follows specific trends, and that prices are always fair. As a result, they conclude that is difficult to outperform the market, and aim for average returns on investments instead.

There is very little decision making with passive management. As a result, it is considered less risky and less expensive, than active investing. Because active managers do not try to predict outcomes, they are unable to take action if the market declines. However, since decisions are made using long-term market data, passive investing often closely matches the performance of an index.

Which Management Strategy is Best?

There is an ongoing debate about which investment strategy produces the best results. In fact, there are times in history where each strategy has outperformed the other. Many argue that the economy and market are always changing and it is impossible to predict outcomes. I believe that each style may have a place in one’s portfolio. A portfolio with a base of lower cost passive investments overlayed with actively managed investments may be a good way to secure your future.

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