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What’s the Difference Between Passive and Active Investing?

There are as many different ways to invest in the stock market as there are investors. However, there are two general categories of investing: active and passive. They require different skills and behavior and may deliver very different results. Before investing or hiring an investment manager, you would do well to understand the ways that the two strategies work.  The difference between the two strategies lies in the way you manage your investments.

What is active investing?

An active approach to investing requires carefully following the markets and buying stocks that are doing well during a certain time period as a means to make a lot of money quickly. You don’t necessarily need to be the one managing the investments. You can invest in a fund with a fund manager who invests in stocks that they believe will outperform the general market. Generally investing actively means monitoring investment positions frequently in order to determine performance.  There is a large spectrum of active investment strategies, from day trading to buying high performing stocks and evaluating them annually. The logic to this investment strategy lies in the belief that the market is not a completely reliable source when it comes to determining winning stocks. With the idea that the market is inherently flawed, active investors seek to exploit the market’s pitfalls in determining the top performers.

So what is passive investing?

Passive investing requires investing in a fund or group of stocks that mimics a certain market. The entire idea is to merely profit from the returns that the market provides.  No effort is made to “beat the market.” Generally a passive strategy is so diverse that reallocation is seldom needed, and often passive funds will reallocate themselves.  The typical investment vehicle for passive investing is called the ETF, or “Exchange Traded Fund.”  This fund is set up with the goal of matching a particular index, such as the S&P 500.  The ETF managers do not trade the stocks based on performance, they only reallocate the funds as the index itself changes.  You can choose your passive strategy by choosing what indexes you would like to invest in.

Over the long term, passive strategies tend to outperform active strategies, especially if you factor in the fees paid to active fund managers.  ETFs generally have very low fees associated with them, while active funds, especially the better performing funds, charge higher fees.  If you actively invest on your own, you avoid the fund or broker fees, but often pay fees on each transaction you execute.

Historically speaking, if an active fund outperforms a passive one, it’s usually in a certain, short time period, but the success is not sustainable. Passive investing means an investment in the future and a plan to continually make money over a prolonged period of time.

This is just the tip of the iceberg of assembling an investment strategy. What’s right for your situation and risk tolerance? For additional information on investing strategies and passive versus active investing, contact an investment manager.

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