Active vs. Passive Investing: Which Is Best?

There are two main ways to invest in the stock market: active investing and passive investing.

Both active and passive strategies allow you to invest your money toward your long-term financial goals, but they both offer a different approach to getting there.

While active investments require research, active market participation, and a keen eye for market moves, passive investments just follow the movements of the market.

So, which one is better? And more importantly, which one will make you wealthy?

Learn about active and passive investing, their workings, performance comparison, pros and cons, and how to choose between the two. Plus we’ll highlight a few examples of both active investing and passive investing funds and strategies.

What Is Active Investing?

Active investing is a strategy for choosing and managing investments that aim to beat the market. With an active strategy, you trade frequently and aim to get better returns than a market index. A market index is a benchmark used to measure the overall performance of a market or specific sector.

To be active in your investing strategy, start by choosing your investments. This may include picking individual stocks, funds, or other securities to invest in, analyzing their performance, and aiming to buy low and sell high to earn outsized returns. 

Platforms like Webull offer a user-friendly interface and access to a wide range of investment options. If you're new to investing, we recommend starting out with a platform like this.

Mutual funds and exchange-traded funds (ETFs)

You'll also see a more active approach in mutual funds and exchange-traded funds (ETFs) that are managed by a team of professionals. These funds choose investments that the fund manager believes will outperform a specific benchmark index. There are usually teams of research analysts that help guide the strategy, and active fund managers that execute the trades.

To be an active manager of your own trading strategy requires constant attention to the details of your investments. Market volatility can lead to portfolio losses; careful risk management is crucial to prevent significant losses over the long term. And even with teams in place and professionals at the helm, most active funds cannot outperform their market benchmark over the long term.

This is why most individual investors would do well to avoid active investing for long-term investing goals, which likely won't even come close to matching average market returns.

Based on a study by Dalbar in 2016, over 15 years (2001 to 2015), individual investors who took an active investing approach averaged a 4.67% annual return, while the S&P 500 index averaged 8.19% annual returns over that same period.

For those who do want to trade actively, it's a good idea to keep the bulk of their wealth in passive funds and use “play money” for individual stock investing.

What Is Passive Investing?

Passive investing is a strategy that involves selecting investments and holding them for a long time. Most passive investors make regular contributions to the investments selected, not trying to time the market, but rather growing their investment balance over time.

These investments typically include index funds or ETFs that are designed to match the industry benchmark performance, not beat it. They simply hold the same investments that are represented in an index (such as the S&P 500 index), and their returns average the same as the index selected.

Index funds or ETFs are “passively managed,” meaning the fund managers aren't doing in-depth analysis and trying to outperform the market through trading. Instead, they just make sure these passive funds mirror the index and occasionally rebalance if necessary.

This passive approach means that index funds and ETFs that follow an index typically have low management fees, and give investors “market average” returns.

But “market average” is anything but — most passively managed index funds outperform their actively managed counterparts over 20 years. 92% of active funds that were attempting to beat the performance of the S&P 500 couldn’t, according to data from SPIVA.

Passive investing is one of the better investment approaches for most investors, especially for inexperienced investors and long-term investors.

Related: What are index funds

Active Investing Pros and Cons

Active strategies can be appealing to investors looking to maximize the growth of their investments. While it's certainly possible to see strong growth in the short term, there are several notable considerations to keep in mind before putting in all the work of active management.

Active Investing Pros

• More investment options: Active investing and active funds don’t have to follow a benchmark, they can choose their investment mix to suit their financial goals. There are more investment options for an active investor vs. passive investors who typically pick from a few different index funds.
• Can adjust quickly: When the market moves, active investors can respond quickly and reshape their investment portfolio. This allows active investors to more quickly adjust to market conditions and preserve their capital, or set up a new investment strategy based on the most recent information.
• Flexible tax management: Active investors have more choices when it comes to tax management. With the ability to sell individual investments to capture losses and more choices for what to invest in. Active investors can create more intricate tax-saving investment strategies.
• Hedging: Most passive investors don’t try to “hedge” their investments, or play both sides of an investment. Active investors can short-sell stocks or funds to gain money if it goes down in value, while also owning those investments to gain from the upside. This is known as hedging and is an advanced investment strategy that most passive investors don’t partake in.

Active Investing Cons

• Poor historical returns: To put it plainly, active investors simply don’t beat their passive investing counterparts most of the time. Individual investors vastly underperform the market with an active investing strategy, while professionally managed funds underperform over longer periods of time.
• Potential tax consequences: Actively trading can cause unintended tax consequences, such as locking in a lot of short-term gains. It can hurt returns even more.
• High fees: Most actively managed funds have higher fees to pay for the in-depth research and management required to run the fund itself. This eats into investor profits and lowers overall returns.
• More risk: Actively trading and trying to time the market is a high-risk activity. It can increase your chance of losses, which leads to poor long-term performance. And if you’re using margin or any form of leverage, those losses can be amplified.

Passive Investing Pros and Cons

Some people aren't interested in being actively involved in managing investments. There are positives and drawbacks to being a passive investor, too.

Passive Investing Pros

• Better overall performance: These investors typically enjoy better returns than most active inventors. This is due to the simplicity of the strategy, low fees, and capturing the performance of an entire market instead of trying to beat it.
• Much lower fees: They pay much lower fees when investing in index funds and ETF index funds. This is because there is no need for a large management team
• Potential for lower taxes: There won't be a lot of trading with your investments, and therefore you won’t typically have short-term capital gains. This lowers your overall tax burden. You can also tax-loss harvest. Sell index funds that are currently down to capture losses — lowering your tax burden even further.
• Lower risk: Passive investing involves buying broad-market funds that offer more diversification and thus less investing risk. Fund managers are simply trying to mirror a given index, and don’t try to time the market or actively trade. This lowers risk significantly.

Passive Investing Cons

• Less flexibility: You can’t pivot as quickly if markets change. And might be more exposed in a bear market, as passive investing strategies don’t sell based on market sentiment. This can also be an upside, but something to know if you choose to passively invest.
• No meme stocks: Passive investors aren’t putting their retirement funds into GameStop stock. These holdings are boring, and you don’t usually jump on the bandwagon of hyped-up investments.

How to Choose Between Active vs. Passive Investing

First off, it's important to know that you don't have to choose between one or the other. You can have the bulk of your money in a boring index fund. And still have a bit of money you use to dabble in individual stocks. This allows you to take advantage of the long-term benefits of index funds while still being able to jump on trends.

Choose active investing if you prefer detailed research. Investing in individual companies, or creating a portfolio based on market sentiment and fundamentals. With short-term investing goals, you may favor more control over investments rather than actively managing them for optimal flexibility.

For a long-term investor without time for daily management, passive investing could be the optimal choice due to its simplicity. Passive investing makes it easy to “set it and forget it” by simply setting up recurring investments into index funds and ignoring the market.

No matter which investment strategy you choose to follow for your portfolio management, it’s important to weigh the pros and cons of each before putting your money in the market.

FAQs

What is an example of active and passive investing?

Active investing involves timing the market, and waiting for price drops to invest in a single company stock or fund. Another is choosing to invest in an actively managed mutual fund that aims to beat a market index.

Passive investing is choosing an index fund for your retirement accounts. Or simply choosing a portfolio of passive ETFs or index funds, and setting up a recurring investment each month.

I’m new to investing, should I choose active or passive?

New investors are better served with passive investing in most cases. Passive investing features low fees, and diversification with index funds, and often outperforms most active strategies over the long term. If you're not sure where to start, Webull provides access to stocks, ETFs, and other options, which can be suitable for passive investors who prefer a buy-and-hold strategy.

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