The Pros & Cons of Active vs Passive Investment Strategies

It’s both a common debate in the investment world and a question we’re often asked by our clients at WestStar: ‘Which is better—active or passive investing?’ Like many other financial conundrums, there’s no stock answer because individual investors have particular goals, timeframes and risk profiles.

Only when these are weighed together, does the answer become clear.

Key Findings

• If you want to invest, you should be prepared to do it for the long term.
• Active investment offers the opportunity to beat the market.In any year, some stocks and actively-managed funds outperform the market.
• Active Investment has higher total costs:research costs, trading costs and taxes increase fees for actively managed funds.
• Markets are complex and an investor must time the market right twice—when buying and when selling—to beat the market. Over time, your chances of continually outperforming the market decrease.
• Passive investment typically has fewer trading and research costs, and lower taxes.
• Since the securities in passive funds aren’t actively traded, by holding onto them for the long term, you benefit from long-term capital gains tax rates.
• Passive investment has less volatility.Diversified portfolios are subject to market risk but not the volatility associated with active investment.

What are the goals of active and passive investing?

Active and passive investing both aim to capture the value inherent in the appreciation of the market. While both strategies aim to minimize the risk inherent in a depreciating market, investors should expect market volatility no matter the strategy they use.

The differences lie in the fact that active investing tries to outperform the market average, while passive investing aims to capture the long-term appreciation of the market.

Who Should Choose an Active Investing Strategy?

If you like the idea of chasing superior returns to beat the market and are comfortable with the risk and costs associated with it, active investing is your best bet. If you or your fund manager pick the stock that outperforms the market, it will give you a chance (naturally) to brag to anyone who’ll be prepared to listen.

What are The Advantages of an Active Investing Strategy?

Active investing offers several advantages for those willing to actively manage their investment portfolios:

1. Potential for Higher Returns: Active investors aim to outperform the market by selecting particular investments they believe will increase in value by a greater than market average. To do so, investor must accurately predict market movements.
2. Flexibility: Active investing allows for greater flexibility in responding to market changes. Investors can quickly adjust their portfolios to take advantage of short-term opportunities or to mitigate risks.
3. Ability to Hedge: Active investors can use strategies such as short selling, options, and other derivatives to hedge against market downturns, which can protect their portfolio during volatile periods.
4. Customization: Active investing provides the ability to tailor a portfolio to an individual’s specific financial goals, risk tolerance, and investment preferences. This can be particularly beneficial for investors with unique financial situations.
5. Opportunity for Value Investing: Active investors can engage in value investing, where they select undervalued stocks that have the potential for growth. This strategy requires deep analysis but can lead to significant gains if the market eventually recognizes the value of these stocks.

What are The Disadvantages of an Active Investing Strategy?

Active investing is more complex due to the research it requires. It’s also riskier. There’s an inherent risk to investing in the stock market, which correlates to expected returns. Individual active investors are compensated for this risk with a higher expected return compared to more conservative options like investing in a high-yield savings account.

Disadvantages include:

1. Higher Costs: Active investing often involves frequent buying and selling of assets, leading to higher transaction fees, commissions, and taxes. Management fees for actively managed funds are also higher than for passive funds.
2. Time-Consuming: Active investing requires continuous monitoring of the market, analyzing data, and making timely decisions. This may require a significant amount of effort and expertise.
3. Higher Risk: Because active investors aim to outperform the market, they often take on higher risks. There’s always the possibility of making incorrect predictions or poor investment choices, which can lead to losses.
4. Performance Inconsistency: Even skilled active investors may experience periods of underperformance compared to the broader market. Consistently beating the market is challenging, and many active managers fail to do so over the long term.
5. Emotional Stress: The active approach can be stressful due to the need for constant decision-making. Emotional reactions to market fluctuations can lead to poor decision-making, such as panic selling or overtrading.
6. Lack of Diversification: Active investors sometimes concentrate their investments in a few assets they believe will outperform, which can lead to a lack of diversification. This concentration increases the risk if those assets perform poorly.

What are The Risks of an Active Investment Strategy?

Theoretically, in an active investment strategy you take on extra risk in exchange for a better return, but historical data shows that’s not what always happens.

The reason for this is that investing in a single stock or small concentration of stocks adds specific risk—beyond what you’d assume simply by investing in the stock market—without a corresponding increase in expected return.

This additional risk often does not result in a premium on the expected return compared to buying stocks aggregated in an index-like fund. It is nearly impossible to consistently predict which investments will beat the market and you’re not likely to win consistently according to the S&P Indices Versus Active (SPIVA) Scorecard. Even if a fund beats the market this year, history suggests the likelihood that it will continue performing above the market average decreases with each passing year.

What is a Passive Investing?

Passive investing makes no attempt to predict which investments will outperform the average.  You won’t find passive investors trying to time the market or cherry-pick funds. Passive investors invest in passively managed funds that represent the make-up of the stock market or a subset of it. As a result, the performance of a passively managed portfolio is almost identical to the performance of the market.

They include hundreds of different stocks—each weighted based on the overall composition of the U.S. stock market.

What are The Advantages of a Passive Investment Strategy?

A passive strategy will typically serve you best if you’re investing for the long haul. It may not be a white knuckle ride, but it’s a strategy to harness consistent market growth, over time. Passive investing offers several advantages that make it an attractive strategy for many investors. These include:

1. Lower Costs: Passive investing attracts lower fees and expenses compared to active investing. Index funds and ETFs ̶ which are commonly used in passive strategies─ have lower management fees since the aim is to replicate the performance of a market index rather than individual investments.
2. Simplicity and Convenience: Passive investing is straightforward and requires less time and effort. Investors can simply buy and hold a diversified portfolio of index funds or ETFs, reducing the need for constant monitoring and decision-making.
3. Lower Risk: By diversifying across a broad range of assets, passive investing reduces the risk associated with holding individual securities. Passive funds track entire markets or sectors and are less susceptible to poor performance of any single investment.
4. Consistent Performance: Passive investors aim to match, rather than beat, the market. Over the long term, markets tend to grow, and passive strategies can deliver consistent returns that align with overall market performance.
5. Tax Efficiency: Passive strategies often result in lower capital gains taxes because they involve less frequent trading.
6. Long-Term Focus: Passive investing encourages a long-term investment approach, which helps investors avoid the pitfalls of market timing and emotional decision-making.
7. Reduced Emotional Stress: Since passive investing requires less frequent decision-making, investors are less likely to react emotionally to market fluctuations. This can help avoid common investment mistakes like panic selling during market downturns.

These advantages make passive investing a popular choice for individuals seeking a low-cost, low-maintenance approach to building wealth over time.

What are The Disadvantages of a Passive Investment Strategy?

If you’re looking for a shortcut to get ahead overnight, passive investing is not the solution. You won’t get rich quick. Passive investing builds wealth with the power of the compound growth of the broad markets and economy over the long-term. Disadvantages include:

1. Limited Upside Potential: Passive investing aims to match market returns, not beat them. This means that investors miss out on the potential for higher returns that can be achieved through successful active management, particularly in a bull market.
2. Lack of Flexibility: Passive investors are typically locked into a fixed investment strategy that tracks an index. This means they cannot easily adjust their portfolios to seize short-term opportunities or avoid sectors that may be underperforming.
3. Exposure to Market Downturns: Since passive investing follows the market, investors are fully exposed to market downturns.
4. Overexposure to Certain Sectors or Companies: Some market indexes may be heavily weighted toward certain sectors or companies, leading to concentration risk. For example, a technology-heavy index may expose investors to more risk if the tech sector experiences a downturn.
5. No Control over Holdings: Investors in passive funds have no say in the specific securities included in the index. This can deter those who want to avoid certain industries or companies due to ethical concerns or other personal preferences.
6. Potential for Lower Returns in Inefficient Markets: Passive investing works best in highly efficient markets where all available information is reflected in asset prices. In less efficient markets, active management might have an advantage in identifying mispriced assets and achieving higher returns.
7. Not Tailored to Individual Goals: Passive investing is a one-size-fits-all approach. It may not align perfectly with an individual’s specific financial goals, risk tolerance, or investment time horizon. Active investing allows for more customization to meet personal financial objectives.

What is Evidence-based Investing?

Evidence-based investing is a particular approach within passive investing that we recommend to many of our clients at WestStar. It involves making decisions based on research and historical (market and performance) data, rather than focusing on short-term market trends or the current investment climate.

In this way, it combines the long-term market growth of a passive strategy along with research that guides you on how to allocate your portfolio.

Evidence-based investing has three main principles:

1. It is data driven.This type of investing is based on peer-reviewed research of historical market performance.
2. It is time-tested.Evidence-based investing involves strategies that have been shown to work for the last 40+ years.
3. It is based on robust analysis. Decades of research have identified patterns and behaviors that repeat themselves and are more likely to be successful.

If you have questions about your specific investment goals, or want to talk about developing an active or passive investment strategy to address your goals and aspirations effectively, please get in touch.

We welcome the opportunity to chat with you and wish you every success in the future.

Sam Gullette & Erik Alexander