Sitting idle with accomplished sums of money is never the objective for any investor looking to make long-term growth. Consequently, when investors look to grow their net worth, the stock market is often the preferred choice. Although stocks and the stock market aren’t the most straightforward investment vehicle to navigate, they offer investors a wide array of options to gain exposure to products, services, and trends spread across the global economy.
With so many choices and investment strategies available, knowing how and when to invest in the stock market remains paramount to capturing and profiting from the many opportunities to begin or grow an investment portfolio.
A primary decision to make when investing in the stock market is whether to take a passive or an active approach, as these strategies differ significantly in risk, cost, and effort. With passive investment strategies, investors often select a portfolio of investments, rebalance allocations as needed, and hold onto those investments for a longer period. In contrast, with active strategies, investors must invest additional time to consider fundamental or technical factors before selecting and trading stocks or securities. Such strategies come with (albeit arguably smaller) amounts of risk due to the market’s volatility and the inherent uncertainty that exists in predicting a security’s direction or valuation.
In this article, we’ll take a closer look at what passive and active strategies entail, their advantages and disadvantages, and which one might best fit your needs as an investor with a portfolio in the stock market.
What is Investing in Stocks?
Investing in stocks is the process of buying and selling equity shares in public companies located all over the world. Stocks are units of ownership that publicly traded companies issue, and they represent a fraction of a company’s ownership and entitle its holders to vote and potentially receive any dividend payout. Therefore, when stocks go up in value, holders of stocks can potentially get a return on their investment. Conversely, when stocks go down in value, holders may take a loss.
In addition to the reward and the risk of investing in stocks, investors must bear in mind that stocks are not always in the same direction. Therefore, different strategies arise, allowing investors to navigate the stock market’s volatility and profit from the different possibilities under different market conditions.
What is Active Investing in Stocks?
Active investment involves making decisions about when to buy and sell stocks, a process known as stock picking, rather than simply buying and holding a portfolio of stocks. Therefore, active investing requires skill and knowledge as the investor predicts the market’s movements and attempts to time the markets to make a profit from the differing stock prices.
Active investors must analyze each stock they’re considering, analyze which stocks may be undervalued or overvalued, predict its short- and long-term performance, then buy and sell those securities accordingly in order to minimize their losses and maximize their profits. Active investors take on a substantial risk, as the stock market is inherently volatile and risks of loss are heightened due to misinterpretation of data, market movements, and made decisions.
Advantages and Disadvantages of Active Investing Strategies
Advantages
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Potential for Higher Returns: Because an active investor is actively trading and making decisions, the investor is generally well-positioned to gain from day-to-day price movements. As such, active investors have the potential to realize higher returns than passive investors.
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Lower Commission Fees: Trading equities actively is usually a lower-cost way of investing compared to traditional investments and mutual funds, which often come with higher commissions beyond the base cost of the investment.
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Familiarity: Active investing often allows investors to develop an inherent understanding of the market and the stocks they’re trading. As such, the thought process of active investors can often become better aligned with that of the stock market.
Disadvantages
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Time Intensive: As active investors must continually monitor and make decisions on markets, such strategies require a lot of time and effort as extensive research and analysis of the markets is required for a long-term success.
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Higher Risk: The stock market is subject to a substantial amount of uncertainty and volatility. The risks associated with active investing are much higher than with some passive strategies, as the variables and outcomes of the stock market are limitless and unpredictable.
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Emotional Investing: As active strategies require investors to make investment decisions, traders often make decisions that are driven more by emotions than rational thought process, leading to impulsive decisions that can hurt an investor’s portfolio.
What is Passive Investing in Stocks?
Passive investing in stocks, often referred to as indexing, is a type of investing that involves buying and holding predefined collections of stocks or securities in order totrack the performance of the overall stock market. As such, passive investors do not need to attempt to pick individual stocks in order to gain exposure to different sectors, as passive investors often use index funds and exchange-traded funds (ETFs).
Advantages and Disadvantages of Passive Investing Strategies
Advantages
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Less Time Intensive: Passive investing requires far less time to perform than active strategies. Passive investors do not need to research and time the markets when purchasing and selling securities, as the job of managing a portfolio is left to the fund managers.
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Lower Cost: Passive investing strategies typically have lower fees due to lower trading costs and the general expenses associated with passive investments. Fees from an ETF or index fund, for example, may be as low as 0.2% or less for managing a portfolio, as opposed to fees of 1% or more for actively-managed funds.
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Reduce Emotional Investing: As passive investors leave the arduous task of picking individual stocks to fund managers, they are able to alleviate the emotional stress of buying and selling stocks, avoiding the urge to purchase higher-risk and often-volatile stocks.
Disadvantages
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Limit to Returns: Passive strategies limit a portfolio’s returns to the market’s returns, as a passive investor’s wealth is determined by the returns of the overall stock market. Therefore, any outperformance of the market by individual stocks will be insignificant to a passive investor’s returns.
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Limits in the Market Exposure: As passive strategies offer diversification of the markets, they can often limit the amount of exposure an investor might want to gain in any specific sector. Consequently, investors may be missing out on high-growth potential sectors and stocks which are taking place as the markets shift.
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Lower Liquidity: Passive strategies often rely on ETFs and index funds, which can come with lower liquidity than individual stocks. Consequently, investors may be tempted to pay more to cover bid-ask spreads, an overage they wouldn’t encounter with individual stocks.
Ultimately, the type of investment strategy that’s best for you as an investor comes down to your individual needs, risk appetite, and understanding of the stock market. Active investing requires deeper understanding of fundamental and technical factors, and investors must be prepared to take on a higher risk than passive strategies. Comparatively, passive strategies require far less time and effort, but have a lower return potential and leave less room for outperformance. While either strategy can be advantageous for investors, it’s important to consider one’s portfolio and what best fits the individual strategy before making decisions on the different investments in the stock market.
