Active VS Passive Investing: The dilemma of every investor

“If you want to win big, you need to keep finding opportunities. Take risks.”

“I watch the market everyday. My phone is filled with buy and sell price alerts.”

“I heard that this company will be divesting a part of themselves away. Want to buy?”

“I don’t have time to monitor the market. It’s stressful to see their value go up and down.”

“I’m too busy working to care about stocks, and I hate looking at numbers.”

“I like ETFs and mutual funds because I don’t need to keep staring at them everyday.”

Are any of these comments familiar to you? How true are they, and how exactly do investors end up choosing the active or passive investment camp?

What is Active Investing?

If you spend time to regularly analyse what new stocks, bonds, or funds to buy, or consistently examine and rebalance your portfolio, you may be an active investor. Similarly, if you are highly engaged in managing your wealth manager, you may also be an active investor. Essentially, the more active you are in reviewing your portfolio, the more active you are at investing.

Active investing tends to incur higher expenses due to the increase in transactions, as well as a fee paid to fund managers or wealth advisors.

Why do people invest actively?

Proponents of the active investing camp believe that their research, analysis and expertise can result in a better performing portfolio. They feel that selectively choosing investments can help them beat the market and outperform a specific index or benchmark, such as the STI or S&P 500. These investors tend to have good knowledge of the investment product that they are investing in, and are apprised on its news and updates.

What is Passive Investing?

If you are a busy working professional who adopts a less hands on approach to investing, you may be a passive investor. You may not have the time, knowledge, or appetite to assess which investment vehicles to purchase, or to monitor the price changes regularly. You are also comfortable matching the performance of a preferred market index.

Passive investing is comparatively cheaper because there is no need to pay portfolio managers or research analysts, and there are lesser trading charges.

Why do people invest passively?

Passive investors are of the opinion that active managers overpromise, and cannot consistently outperform a passive benchmark. According to S&P Dow Jones Indices, 90% of active fund managers failed to beat their index targets over the previous one, five, and 10 years. This may explain why passively managed US equity funds saw a dramatic increase in market share from 12% in 2000, to 24% in 2010, and 48.1% in 2018.

Does active or passive investing perform better?

Well, it depends on a multitude of factors such as the current economic outlook, market sentiments, market efficiency, investment type, and more.

According to Morgan Stanley Wealth Management, active managers are likely to outperform when the market is volatile and can help investors improve their risk-adjusted returns amidst market stress. This is, of course, subject to the expertise of the active managers. However, successful active investing has also historically proven to be more difficult, especially when it comes to certain asset classes such as the stocks of large US companies.

Ultimately, it all boils down to market efficiency, which describes the extent to which asset prices quickly and rationally adjust to reflect new information. In highly efficient markets like that of the S&P 500, any new market information is transparent and will quickly be reflected into prices. Mergers and acquisitions, divestments, Memorandum of Understandings (MOUs) signings, new project clinches, financial reports, management changes, and even scandals will be reflected into its price. As such, it is impossible to consistently achieve above average risk-adjusted returns in this type of market.

During stable economic times, and in highly efficient markets, passive investing may give comparatively better returns due to their lower cost incurred. On the other hand, in less efficient markets typical of rapidly developing countries such as China or India, there exists opportunities for active investing to bear fruit.

A mix of both active and passive investing is your best bet

Thankfully, there is no need for you to pick a side.

Having a healthy mix of both active and passive investing helps you diversify your investment strategy. However, the exact ratio of active and passive investing, as well as the list of investment items to purchase for each portfolio, will differ greatly from individual to individual. It depends on your risk tolerance, return expectations, liquidity preferences, and more.

When in doubt about what to invest in and how to go about doing it, seek the help of a professional financial advisor. At LFA, your life comes first. We can help you devise the most suitable portfolio to reach your personal life goals and priorities.

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