There are two main ways to invest in the stock market: active investing and passive investing.
Active investments require research, active market participation, and a keen eye for market moves. Passive investments just follow the movements of the market.
But which one is better? And more importantly, which one will make you wealthy?
What Is Active Investing?
Active investing is a strategy of choosing investments that you think will 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.)
Being an active investor includes picking individual stocks, funds, or other securities to invest in, analyzing their performance, and aiming to buy low and sell high.
You'll generally see a more active approach with mutual funds and professionally managed exchange-traded funds (ETFs).
Active investing requires constant attention to your portfolio. Market volatility can lead to losses, and even with professionals at the helm, most active funds can't outperform their market benchmark over the long term.
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.
This is why most people should avoid active investing for long-term goals. If you do want to trade actively, keep the bulk of your wealth in passive funds and use “play money” for individual stock investing.
Pros and cons of active investing
Active strategies can be appealing when you want to maximize growth. But while it's possible to see strong returns in the short term, there are some things to keep in mind.
| Pros | Cons |
|---|---|
| More investment options. Passive investors typically only pick from a few different index funds. | Poor historical returns. Active investors vastly underperform the market. |
| Can adjust quickly. When the market moves, active investors can respond quickly and reshape their portfolio. | Potential tax consequences. Actively trading can lock in a lot of short-term capital gains. |
| Flexible tax management. With the ability to sell to capture losses, active investors can create more tax-saving strategies. | High fees: Most actively managed funds have higher fees to pay for the research into them. |
| Hedging. Active investors can short-sell stocks or funds that go down in value, while also owning those investments to gain from the upside. | More risk: Actively trading can increase your risk of losses. And if you’re using margin or any form of leverage, those losses can be amplified. |
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 their investments, regardless of how the market is performing. They're not trying to time the market, but rather grow their investment balance over time.
Passive investments typically include index funds or passively managed 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), and their returns average the same as the index selected. There's no in-depth analysis or trying to outperform the market through trading.
Index funds and ETFs 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. In fact, according to data from SPIVA, 92% of active funds that were attempting to beat the performance of the S&P 500 couldn’t.
Passive investing is generally better for inexperienced investors and long-term investors.
READ MORE: How To Start Investing
Pros and cons of passive investing
Some people aren't interested in actively managing their investments, although there are some drawbacks to consider.
| Pros | Cons |
|---|---|
| Better overall performance. Passive investors typically enjoy better returns than most active investors. | Less flexibility. You can’t pivot as quickly if markets change, and might be more exposed in a bear market. |
| Much lower fees. Because there's no need for a large fund management team, passive investors pay lower fees. | No meme stocks. Passive investing can feel boring —you don’t jump on the bandwagon of hyped-up investments. |
| Lower risk. Passive investing involves broad-market funds that offer more diversification and less risk. | |
| Potential for lower taxes. Without a lot of trading, you won’t typically have short-term capital gains. You can also tax-loss harvest (sell index funds that are currently down to capture losses). |
How to Choose Active or Passive Investing
First off, 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 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 have short-term financial goals and want to research. You'll be investing in individual companies and creating a portfolio based on market sentiment, and will have more control.
- Choose passive investing if you're a long-term investor without time for daily management. Passive investing makes it easy to “set it and forget it” by simply setting up recurring investments and ignoring the market.
No matter which investment strategy you choose for your portfolio, it’s important to weigh the pros and cons of each before putting your money in the market.
To get started, you can use an online investing platform like Webull, which offers a user-friendly interface and access to a wide range of investment options.
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 stock or fund. Or investing in an actively managed mutual fund that aims to beat a market index.
Passive investing is choosing an index fund or passive ETFs and setting up a recurring investment each month.
I’m new to investing — should I choose active or passive?
In most cases, new investors should choose passive investing. You'll get lower fees and diversification through index funds. Plus, passive investing often outperforms most active strategies over the long term.
TL;DR: Passive vs. Active Investing
Most new investors should go passive. Index funds and passive ETFs charge lower fees and historically outperform the majority of actively managed funds.
Active investing requires constant attention and research, and even professionals struggle to consistently beat market benchmarks over the long term.
That said, you don't have to pick one or the other. Keep the bulk of your money in passive index funds for long-term growth, then use a small amount as “play money” to pick individual stocks if you enjoy the hands-on approach.
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