Active vs Passive Investing

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When it comes to investment styles there is a constant debate about whether an active or passive investing approach is superior.

What is active investing?

Active investing is based on the belief that stocks on the stock exchange do not always trade at fair value.

In other words markets are ‘inefficient’, resulting in stocks at times trading for more or less than they are actually worth, creating opportunities which can be exploited.

Active managers attempt to beat the market, whereas passive managers attempt to be the market.

Investment managers that follow this approach typically buy stocks at times when they deem them to be trading at favourable levels.

This style is considered ‘active’, because it involves actively deciding which stocks are under- or overvalued, as well as deciding when to buy or sell these stocks.

What is passive investing?

Passive investing follows the belief that stocks on the stock exchange trade at fair value, thereby making markets ‘efficient’ and rendering individual stock picking futile.

Asset managers that use this investment style therefore invest in a market index as opposed to picking stocks individually.

A market index or indices can be defined as the value of the stock market as a whole or certain sections thereof.

This style is considered ‘passive’, because it does not involve deciding which stocks to buy or sell and instead tracks the relevant index.

Active investing basics:

Outperformance

Correctly applied insight by fund managers can lead to active funds outperforming market indices and their passive counterparts.

Flexibility

By following an active approach fund managers are able to take action if they believe markets are in decline or certain individual stocks need to be sold.

Fee structure

Active investing is more expensive than passive investing due to the higher operating costs involved.

Risk

Active investing is typically characterised by funds that have more concentrated selections of stocks in their funds, which potentially increases the level of investment risk involved.

This can be seen as both positive and negative due to the fact that this concentrated selection of stocks can enhance positive or negative returns.

Passive investing basics:

Low fee structure

Due to the fact that passive investing has lower operating costs, it is characterised by lower fees than active investing.

Less decision-making required

Passive investing does not require decision-making in terms of stock selection or market outlook.

Lack of control

Managers are unable to take action if they believe markets will decline or if they believe that individual stocks should be sold for whichever reason.

Index correlation

Passive investing tracks market indices. This can be seen as both positive and negative, as you will always achieve a return just shy of the index you are tracking. You will therefore never be able to outperform the index.

Conclusion

In conclusion it seems only fitting to quote one of the most successful active investors of all time, Warren Buffett: “I’d be a bum on the street with a tin cup if markets were efficient.”

Active managers attempt to beat the market, whereas passive managers attempt to be the market.

It therefore makes sense to opt for an active investment approach, provided that the fund manager you choose charges reasonable fees that can be justified by a consistent long-term track record of acceptable performance.

[tip title=”moneysmart tip”]Investment fee structures should always be considered when investing as excessive fees can prove to be a hindrance to the compounding of your returns over the long term.[/tip]
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About Author

Raul Jorge is a CFP® professional at PSG. He specialises in estate, investment, retirement and risk planning. Prior to joining PSG, Raul completed his BSc (Honours) in Business Administration through the University of Wales and more recently completed his Postgraduate Diploma in Financial Planning through the University of Stellenbosch.