Active investing is like betting on who will win the Super Bowl, while passive investing is like owning the entire National Football League, thus collecting profits from ticket sales and merchandise regardless of which team wins each year.
Using the Investment Analogy of the National Football League
Using the investment analogy of the National Football League, you will study all the players and coaches, attend the offseason practices, and based on your research, you will bet on the teams that will be on top this year. Are you willing to bet on your ability to make the right choice? Active investors or active strategies do just that.
Comparing Active Investment Funds with Passive Investment
When looking at investment funds, an active large-cap equity fund will try to select the best 100 to 200 stocks listed in the S&P 500 index. Meanwhile, a passive investment fund, or index fund, will own all 500 stocks listed in the S&P 500 without attempting to choose among them.
Annual academic studies are conducted to compare the returns of active funds with the returns of passive funds. Studies indicate that overall, in the long term, active funds do not provide higher returns than their passive counterparts, and the reason for this is related to fees.
Active funds typically incur higher costs. The fund manager has to generate excess returns first to cover the costs before the investor starts seeing better performance than the comparative index fund.
Why does the active approach cost more? It takes time to conduct research, and active investment funds tend to spend more money on overhead and staff. Also, they have higher trading costs when moving in and out of stocks. If the index yields 10%, and the fund has 3% in annual costs, it must generate 13% just to achieve a net return equivalent to its index.
There is also a difference between passive investment funds and index funds. All index funds are a form of passive investment, but not all passive funds are index funds.
Confusions About Active vs. Passive Investing
Often, the focus in the debate between active investing and passive investing is on whether an investment fund can outperform its index. For example, studies may look at the number of large funds that outperform the S&P 500 index. However, many funds and investment approaches are not limited to a specific type of stocks or bonds.
For instance, multi-cap equity funds may be allowed to hold large or small-cap stocks based on what research analysts believe may perform best. In this case, you can measure the long-term results of such a fund against something like the total stock market fund from Vanguard.
Additional confusions arise from the fact that investment advisors may use passive index funds, but they can use a tactical asset allocation approach to decide when the portfolio should hold more or less of a specific asset class. In this way, passive investment funds are used within an active or semi-active approach.
Passive Investing Captures Overall Market Returns
Passive investors want to own as many opportunities as possible. They assume that in the long run, they are more likely to achieve higher returns by investing in an entire index group rather than trying to pick individual outperforming stocks.
The goal of the passive market approach is to take advantage of something called the equity risk premium, which states that you should be compensated for taking on equity risks with higher returns.
Investment
Passive is More Tax Efficient
There is not a lot of trading done with passive funds, so they have lower fees. They also distribute fewer capital gains that will flow into your tax return. If you invest using non-retirement accounts, this means that ongoing passive investing should help reduce your tax bill.
If you want to combine active and passive approaches, you might consider placing the money managed by active mutual funds inside tax-protected accounts like individual retirement accounts while using a passive approach or tax-managed fund for non-retirement accounts.
Passive Investing is Best for Most Investors
How many of your friends or coworkers have said they follow a passive investing strategy? Probably very few, but they should. Very few people can make money as active investors, and for those who can, only a small percentage of those people will beat the market over the long term.
Do not view investing as a way to make money quickly. The most successful investors are those who invest for the long term and understand that compound returns over time with reasonable risks are how to build wealth.
Source: https://www.thebalancemoney.com/actively-managed-investing-vs-index-funds-2388517
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