Active vs. Passive Investing: Which is Better?

The news has been the same for over a decade: More money is flowing out of actively managed investment funds and into passively managed funds.^[0]

Active vs. passive investing

The biggest difference between active investing and passive investing is that active investing involves a fund manager picking and choosing investments, whereas passive investing typically tracks an existing group of investments called an index. Passive investing strategies often perform better than active strategies and cost less.

Understanding active and passive investing

Active investors research and follow companies closely, and buy and sell stocks based on their view of the future. This is a typical approach for professionals or those who can devote a lot of time to research and trading.

Passive investors buy a basket of stocks, and buy more or less regularly, regardless of how the market is faring. This approach requires a long-term mindset that disregards the market’s daily fluctuations.

Similarly, mutual funds and exchange-traded funds can take an active or passive approach.

Active fund managers are buying and selling every day based on their research, trying to ferret out stocks that can beat the market averages

Passive fund managers are content to be the market average, hitching themselves to a preset index of investments, such as the Standard & Poor’s 500 index of large companies or others

And investors can mix and match. They can be active traders of passive funds, betting on the rise and fall of the market, rather than buying and holding like a true passive investor. Conversely, passive investors can hold actively managed funds, expecting that a good money manager can beat the market.

» Prefer the passive approach? See our picks for top robo-advisors

Passive investing tends to perform better

Despite the fact that they put a lot of effort into it, the vast majority of of active fund managers underperform the market benchmark they're trying to beat.

Even when actively managed funds do experience a period of outperformance, it doesn't tend to last long.^[0]

With so many pros swinging and missing, many individual investors have opted for passive investment funds made up of a preset index of stocks or other securities.

Passive investing tends to be cheaper

Passive funds buy and sell stocks mechanically. Investors in passive funds are paying for computer and software to move money, rather than a high-priced professional. So passive funds typically have lower expense ratios, or the annual cost to own a piece of the fund. Those lower costs are another factor in the better returns for passive investors.

Funds built on the S&P 500 index, which mostly tracks the largest American companies, are among the most popular passive investments. If they buy and hold, investors will earn close to the market’s long-term average return — about 10% annually — meaning they’ll beat nearly all professional investors with little effort and lower cost. An active fund manager's experience can translate into higher returns, but passive investing, even by novice investors, consistently beats all but the top players.

That hardly sounds like “settling” for a passive approach. In fact, billionaire investor Warren Buffett recommends buying low-cost S&P 500 index funds regularly as the best option for regular investors.

While S&P 500 index funds are the most popular, index funds can be constructed around many categories. For example, there are indexes composed of medium-sized and small companies. Other funds are categorized by industry, geography and almost any other popular niche, such as socially responsible companies or “green” companies.

While some passive investors like to pick funds themselves, many choose automated robo-advisors to build and manage their portfolios. These online advisors typically use low-cost ETFs to keep expenses down, and they make investing as easy as transferring money to your robo-advisor account.

» Want active investment management? Look at our top brokers for mutual fund investors

For passive investing to work, you have to stay invested

To get the market’s long-term return, however, passive investors have to actually stay passive and hold their positions (and ideally adding more money to their portfolios at regular intervals).

For most investors, the first step toward being active can mean taking a bite out of their potential returns. Investors are tempted to:

• Sell after their investments have gone down in value

• Buy after their investments have gone up in value

• Stop buying funds after the market has declined

Even active fund managers whose job is to outperform the market rarely do. It's unlikely that an amateur investor, with fewer resources and less time, will do better.

In the chart above, you can see how a passive S&P 500 indexing approach compares with the performance of all stock funds (both active and passive) during various periods over the past 30 years, as measured by Dalbar, an independent evaluator of financial performance. A passive approach using an S&P index fund does better on average than an active approach.

Active funds vs. passive funds

Let’s break it all down in a chart comparing the two approaches for an investor looking to buy a stock mutual fund that’s either active or passive.

In the end, passively investing in passive funds looks like the winner for most investors.

Perhaps the easiest way to start investing passively is through a robo-advisor, which automates the process based on your investing goals, time horizon and other personal factors. The robo-advisor selects the funds to invest in. Many advisors keep your investments balanced and minimize taxable gains in various ways.

Almost all you have to do is open an account and seed it with money. And then back away.

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