Understanding the difference between passive and active investing is key to implementing a sound investing strategy. So without further ado, let’s dive into it.
If you’re a passive investor you’re typically someone who chooses to have a buy and hold the portfolio for the long term. A passive investor usually has minimal interest in or time for analysing individual businesses. Instead, they would much rather invest in an exchange traded fund (ETF) that tracks an index fund such as the S&P 500. Across the global marketplace, numerous indexes exist that track the performance of a specific group of companies. For example, The S&P 500 is a market capitalisation weighted index that tracks the performance of the largest 500 U.S. publicly traded companies. An index acts as a yardstick for specific stock markets’ overall performance. In 2019 the S&P 500 has surged 29%, indicating that stock prices are roaring higher for most of the U.S. top 500 companies tracked by the S&P 500.
By investing an Index fund like the S&P you believe that in the long run, the companies tracked by your particular index will continue to grow and perform well. Historically, US and Aussie stocks have proven to steadily provide positive returns over the long term. You certainly wouldn’t be crazy to assume the trend will continue. From 1900-2019, the All Ordinaries Index which tracks the average returns of Australia’s largest 500 Companies has achieved an average compounded rate of return of 13.2% (Market Index.com.au). Over in the States, the S&P500 Index has achieved a similar return of roughly 8% from 1956 – 2018 (Investopedia.com).
Why Passive Investing Is Easy
Investing passively through index funds is easy. You can invest in an Index of your choice by buying shares in an ETF that tracks an underlying index. An ETF is a marketable security. That means it has a price from which shares can be bought and sold publicly on the Australian Stock Exchange. IVV is an ETF that tracks the S&P 500 from the ASX, which allows you to track the results of the 500 U.S. companies captured in the index through your Australian share trading account with AUD. How great is that!
Nothing simplifies a concept more than a good old fashioned list of pros & cons, so here goes.
Pros of Passive Investing
- Minimal Research – Passive investors are heavily diversified & set-up to achieve market returns, which requires minimal research. Successful passive investing hinges on following a set and forget approach while you let the market do its thing.
- Tax Efficiency – Employing a set and forget strategy means you’ll pay less capital gains tax at the end of each financial year. As an Aussie, holding your shares for longer than 12 months makes you eligible for the capital gains discount which reduces your tax commitment by 50%. Check out moneysmart.gov.au for more details.
Cons of a Passive Strategy
- Lower Returns – As a passive investor, you will never beat the market because your investment is set up to track the market return. Active investors crave the idea of beating the market. But as you’ll see below, the higher the reward, the higher the risk.
- Conflicting Values – Passive investors need to understand that the operations of certain businesses they’re tracking may not align with their personal values. For example, let’s say you’re a vegetarian. I’m assuming you may not feel comfortable with the idea of supporting a livestock processor forming part of the index you’re invested in. Would I be right in saying that?
In contrast, active investors make the time and effort to carefully select individual businesses to invest in and manage accordingly. The main goal of active investing is to beat the market return consistently. How do you do that? Limit your exposure to businesses that weigh down the market and maximise exposure to businesses that drive the market upward. Active investing might sound like a no brainer, but let me tell you, it’s easier said than done.
Active investors need to understand that buying businesses within their circle of competence is key to a successful investment. The good active investors consider businesses that they’re capable of understanding and have an interest in.
Active investors invest in businesses that they can understand and aim to purchase them when they’re undervalued to maximise returns. The legendary Warren E. Buffett once said, “Simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” If you don’t know who Warren Buffett is, do yourself a favor and Google him ASAP.
Pros of Active Investing
- Potentially Higher Returns – An active investor’s main goal is to beat the market return. Should that goal be achieved, higher than average returns will follow.
- Invest With Meaning – Investing in individual businesses gives investors the opportunity to make investments that have meaning to them. If, for example, Nike products tickle your fancy, you may consider becoming a shareholder.
- Flexibility – Active Investors aren’t bound by any index, they are free to invest in any stock that they like.
Cons of an Active Strategy
- More Time & Effort Required – Active Investing removes the safety of diversification because it involves owning only a handful of businesses within your circle of competence. This means more time and effort through careful analysis is required to minimise downside risk.
- Higher Risk – With higher returns comes higher risk. Active investors are free to choose any investment they predict will provide market beating returns. Hence why this great when you’re right, but terrible when you’re wrong.
So what if you’re not sure if you want to invest passively or actively? Well, do we have great news for you. You don’t need to be sure. A balance of passive and active investments is a perfectly fine investing strategy. As a beginner, you may have 95% of your portfolio in passive investments and the remaining 5% in active investments while you learn how to analyse businesses. Alternatively, if you’re a skilled active investor you might have a 50/50 portfolio.
The beauty of these two investing styles is that you can participate in both depending on your appetite towards risk. What’s important is understanding the relationship between the two and forging a strategy that suits your needs best.
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Disclaimer: This website (the “The Money Pal”) is created and authored by Jesse A (the “Content Creator”) and is published and provided for informational and entertainment purposes only. The information in the Blog constitutes the Content Creator’s own opinions and it should not be regarded as financial advice.