Investing in the share market: Passive or active?
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In this article, we will discuss
There has always been a constant debate over if one should invest in the stock market as an active participant or passively. Well, the truth is, it entirely depends on your strategy and approach towards the market.
If you actively make efforts to outperform the underlying indices, you are an active investor. However, if you aim to make profits by tracing the returns of an index, you are a passive investor. Now before we decide on which trading strategy you should follow on your stock trading apps, let’s take a look at both these investment strategies.
What is Active Investing?
Active share market investment curtails strategies investors use to optimise their returns. The target of such investors is to make returns higher than the market. Such traders imply various techniques to identify entry and exit points for their investments.
As they aim to outperform the market, they put a lot of value in identifying the right time to buy or sell assets. Since it involves technical analyses, an investor must have a good knowledge and understanding of the market.
One example of active investment is equity mutual fund investments. The portfolio manager of these funds decides the stocks he wants to add to the fund and the stocks that he wants to remove from the portfolio. The aim of the fund manager of an equity mutual fund is to always outperform the market and maximise the returns.
Advantages and Disadvantages of Active Investment
These are the following advantages of active investing:
- Active investing gives you the flexibility to make changes as per your own judgement and changing market conditions. It can prove to be advantageous, especially when the markets go bearish.
- It gives you the freedom to invest in securities of your choice.
- Investors with sharp market skills can leverage their knowledge to maximise their returns. They don't need to settle on what markets offer them.
- Active investing and management give investors the opportunity to employ their hedging skills in order to minimise their risks.
- It allows you to offset your losses by selling underperforming securities against your tax liabilities, thus reducing your tax burden.
Now let’s take a look at the disadvantages of active share market investment.
- Active investing strategies are based on the buying and selling mindset. This frequent buying and selling can sometimes lead to a high brokerage cost, thus nullifying whatever profits you have made so far.
- Even though active investors have the flexibility to choose their securities, it can result in great losses if their decisions turn out to be wrong.
- Active investments require constant monitoring of the market and making changes in the portfolio accordingly. Since it can become difficult for individual investors to hawk the market all the time, they can sometimes miss good opportunities or end up making losses on their existing investments.
- If you choose to invest in actively managed funds, the expense ratio of such funds is quite high because fund managers monitor and analyse the funds very closely.
What is Passive Investing?
Passive share market investments are more focused on holding long-term investments. Passive investors usually aim to match the performance of the market as opposed to active investing, where the aim is to outperform the market. Hence, all the strategies implied by passive investors are also dedicated towards the same.
The classic approach of passive investors is to mirror the market. For the same reason. Passive investors engage in the market with a buy-and-hold mentality. Thus they also keep a limit on the number of times they buy and sell a security.
One of the best examples of passive investment is index funds. Every index fund has an underlying index, and the fund manager tries to imitate the portfolio of the underlying index.
Depending on their judgement, they might alter the proportion of a few securities, but it is more or less quite similar to the benchmark index. These are passively managed funds because the fund manager doesn’t actively monitor or analyse the performance of the fund. In the case of these funds, if the benchmark index performs poorly, so will the index funds mirroring it and vice versa.
Advantages and Disadvantages of Passive Investment
- Passive investments are comparatively less costly because these investors do not buy or sell securities in high volume. Hence, the transaction charges associated with their trading volume are also low.
- Even if you invest in a passively managed fund, it would be less costly for you because the passively managed funds have a lower expense ratio.
- Passive investors often put their money in passively managed funds, or they try to mirror the indices some other way. Mirroring an index gives them enough diversification in their investments.
- An adequate diversification of the portfolio also helps them mitigate risk.
- Passive investors do not need to constantly worry about their investments as there is no pressure to outperform the market.
- It also prevents them from having to constantly monitor the markets. Hence passive investing requires very less time and effort from the investor.
- It can be a suitable investment choice for movie traders who are still learning the technicalities of the market.
Now let’s take a look at some factors that can be quite disadvantageous to passive investors.
- Passive investing is usually for the long haul; therefore, the returns can also only be seen in the long run. If you are following a passive investment strategy for a short-term goal, you might not see the desired results.
- Passive investing is not very flexible. Hence you can sometimes also have negative returns on your portfolio. This can create anxiety in some investors.
- Passive investing aims at imitating the market; hence, the returns of passive investing would rarely go beyond the markets. This means limited returns in some cases.
- It is not a very appealing investment strategy for most experienced traders and investors. They would rather prefer to actively manage their portfolio to gain maximum returns rather than wait for the market trends to help them make profits.
Which One Should You Choose?
First of all, there is no need for an investor to become an extremist investor, i.e. choose the extreme end of active or passive investing. Depending on your convenience, you can choose to strike a balance between both strategies and figure out your own investment plan. However, if you still need to decide on one, you can take into consideration the following parameters.
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Investor acumen:
Active investing requires frequent buying and selling and is thus more complex than passive investing. Hence if you have a good grip and understanding of the market, you can choose active investing strategies. However, for novice investors, passive investing may be more accurate.
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Time and dedication:
Active investors need to keep a closer watch on the market. They also need to put time into research and analytics to chalk out their next step with constantly changing markets. If you can't put in so much time and effort, passive investing may be a better choice.
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Investment goals:
Passive investing is more suited to investors with long term goals. On the contrary, active investing can drive better results in the short run.
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Investment cost:
Frequent buying and selling in active investing requires a high investment cost. Whereas in passive investing, this cost is significantly low.
Conclusion
Irrespective of your approach towards the market, share market investments, both strategies come with their own pros and cons. However, for most retail investors, passive investing is a more suitable approach towards the market. If you have been investing for a while now, you can start combining both these methods to gain maximum results.
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FAQ's
Q1. Are mutual funds actively managed or passively?
Ans. If the fund manager closely monitors the funds and adds and removes securities from the portfolio, it is considered to be an actively managed fund. If the fund manager’s role is only to mirror the returns of an underlying index, it is considered to be passive.
Q2. When is active investing a better choice?
Ans. At times when markets are volatile, and the economy is weakening, active trading usually gives better results than passive investing.
Q3. Can passive investing beat the market?
Ans. Passive investment strategies have sometimes beaten the market, but the gap is very small. Hence, the little gap may not be exciting enough for active investors.
Q4. What are some good investment choices for passive investment?
Ans. Investing in index mutual funds, dividend stocks, bonds, etc., can be some of the best asset choices for passive investing.
Q5. Is dividend income an active income?
Ans. Dividend income is a company’s profits that it distributes to its investors. Hence it is a passive income source.