Traders can choose between active and passive investing styles. Both contrasting trading methodologies offer unique benefits and risks to investors.
Let us discuss what active and passive investing styles and strategies are and which is a better choice for investors.
What is Active Investing?
Active investing is an investing style where the investors are actively involved in buying, holding, and selling financial securities to make profits.
The aim of active investing is to beat the market with quick decision-making. Investors buy and sell securities for a short time and seek higher returns than a benchmark or industry average return.
Active investing strategies often rely on smaller profit margins per trade and include several transactions in a single trading day to maximize return on investment.
How Does Active Investing Work?
Active investment management requires special skills and knowledge of stock markets. Portfolio managers utilize the services of a team of analysts and wealth managers to formulate investing strategies.
Active investing requires a deep understanding of the stock market’s fundamental and technical analysis. However, this investment heavily relies on technical analysis.
Active investing is a constant study of the stock market. It includes finding financial securities that are either overvalued or undervalued.
In other words, active investors seek loopholes in the market pricing mechanism and try to beat the market by placing the right type of orders before market corrections.
Unlike passive investing, active investors can take advantage of price movements in either direction of security. For instance, short-selling allows active investors to take advantage of falling prices of a financial asset like a stock or bond.
However, active investing is highly risky. Investors heavily rely on leverage and margin trading to place large orders. It may end up in losing all or significant money.
Active Investing Strategies
Active investors can take several types of trading strategies to maximize short-term profits.
Scalping involves taking advantage of favorable bid-ask spreads. It is a short-term trading strategy that requires identifying small profit margins through a large volume of transactions.
Scalping only focuses on identifying the spreads with abnormalities. It is the strategy of maximizing returns on these spreads before the market makes corrections.
Day trading is a strategy where all trading positions are closed on the same day. It involves buying and selling financial assets on the same day.
This strategy seeks over or undervalues assets, so it is suitable for highly volatile markets. However, a higher degree of volatility means higher risks too.
Swing trading means identifying trend break-ups and making profits before a new trend is formed. It means relying on established price trends of an asset and waiting for the right time when it moves in the opposite direction.
Swing traders place small orders for a few days, relying on technical and fundamental indicators. It is a less risky strategy than day trading or scalping.
Position trading is a relatively medium-term trading strategy. It involves identifying established trends and benefiting from price movements afterward.
It means position traders try to beat the market by placing orders for price movements in either direction by studying the established positions over a month or a few weeks.
Pros and Cons of Active Investing
Pros of Active Investing include:
- It allows portfolio managers to adjust to market volatility quickly. Investors can even turn to the long-term buy-and-hold strategy if feasible.
- It benefits investors to maximize profits through short-term investing goals.
- Active investors have access to a wide range of trading strategies. It helps them achieve different financial goals including hedging, profits, and risk management.
- Investors rely on their skills and knowledge to beat the market benchmarks rather than relying solely on market conditions.
Cons of Active Investing include:
- It involves high risk meaning investors can lose money quickly too.
- It’s a difficult strategy requiring special skills and technical indicators knowledge.
- As it involves a large number of transactions, it is a costly approach.
- Income taxes on active trading profits are higher than long-term capital gains.
What is Passive Investing?
Passive investing is a long-term strategy that requires minimum trading of financial assets. It follows market trends and tries to maximize profits in the long term.
The main ideology behind this long-term approach is that the market rises in the long term. It simply means the prices of financial assets will increase over time.
It does not mean that financial markets will never see a slump. However, it involves holding these financial securities for long enough when they become profitable.
It also relies on minimizing transaction costs and taxes. Thus, the focus is on minimum expenses and maximum profits in the long term.
How Does Passive Investing Work?
Passive investors do not look to time the market. They set a benchmark return and try to achieve the same in the long run. Therefore, they rely heavily on fundamental indicators of the stock market. It does not require depending on small price movements in the short term.
Often, passive investing involves creating a bucket of thousands of financial assets. Eventually, it will include a major chunk of assets going upwards in the long run.
Unlike active investing, this strategy does not follow individual stocks or bonds. It rather tries to follow the investing trajectory of index funds and ETFs.
Passive Investing Strategies
Index investing is a common passive investing strategy. It aims to formulate a diversified portfolio and minimize risk exposure.
An index fund follows the benchmark of the industry or market returns. It includes largely the same set of financial securities as its benchmark portfolio.
Passive investors resist seeking short-term and quick profits through market volatility. Also, they bear small losses in the short term by holding investments for longer periods.
Passive investors can create their own diversified pool of investment as well. However, it requires a significantly higher level of skill and knowledge of trading.
Another key focus area of passive investors is cost reduction. It is achieved through minimum transaction costs, commissions, tax savings, and conversion costs.
Pros and Cons of Passive Investing
Pros of passive investing include:
- Passive investing is a simple strategy and does not require special skills unless traders want to build their own portfolios.
- It comes with a lower level of risk exposure.
- Long-term investing beats the market eventually and generates profits for investors.
- It comes with significant tax savings.
- If traders invest in index funds, it hardly takes any time.
Cons of passive investing include:
- It is not entirely a risk-free investing style and investors may still be prone to risks.
- It offers average returns as compared to active investing.
- It does not come with the flexibility of freely investing in individual stocks or assets.
- Traders must understand the basics of trading and their potential investment opportunities.
Active Investing Vs. Passive Investing – Which One is Better?
The right choice between active and passive investing depends on your financial objectives. If you seek average returns and want to avoid excessive risks, passive investing is the right choice for you. You can follow a successful index fund like S&P500, NASDAQ 100, or Jow Dones Industrial Average.
On the other hand, if you possess essential skills and knowledge of the stock markets, you can pursue active investing. Moreover, it is a good choice if you are willing to take risks.
Another key determinant is the amount of research work and the understanding of the market mechanism. Active investing requires more work than passive investing.