You may have heard about active and passive investing, but if you’re new to investing you may not be sure exactly what these terms mean or how they work.
We get that. There are lots of concepts associated with financial markets and understanding them all can get tricky. When it comes to passive and active investing here’s the basics.
What is active investing?
In a nutshell, active investment funds are run by portfolio managers who are experts in making investment decisions to take advantage of price fluctuations in the financial market.
Active investors try to beat the returns of the index to which it relates — commonly known as its benchmark. The index, for instance the S&P/ASX 200, contains the companies whose shares the fund is buying and selling. With this style of investing, the manager picks stocks to buy then compares the returns they make against the benchmark.
The benefits of this style of investing include the potential for greater profits and returns than market and index funds and greater control over an investment. But be aware, it can also involve much higher management fees and expenses than other investments. It can also underperform the market due to suboptimal investment strategies.
What is passive investing?
Passive investing is a completely different approach. A common example of passive investing is an index fund that invests in major companies such as those included in the S&P 500 (top 500 US public companies) or ASX 200 (top 200 AUS public companies). Typically, the fund will buy all the stocks in the given index in the same proportion they appear in the index.
Investing in an exchange traded fund (ETF) is also considered a type of passive investing when the ETF is tracking an index. ETFs are essentially a combination of assets (such as stocks, cash or bonds), bundled together under one roof to form a single financial product that can be traded on the stock exchange. The ETF is like an index fund, and their value will go up or down in line with the index they are tracking.
Some advantages of passive investing include reduced expenses compared to active investing and the benefits of diversification that comes with index funds. Warren Buffett, the all-time active investor legend advocates for passive investing on the basis even if active investing can yield significant profit quickly, often it is the portfolio manager who is rewarded with high remuneration, not the investor.
Which style is best for me?
Like anything else when it comes to investing, you need to make the right decision for your particular financial needs and circumstances.
Some investors, especially those with more knowledge, are comfortable selecting their own portfolio of funds or taking an active approach to investing. Others, particularly those starting out, may want to take a passive approach to investing.
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