Even with the onset of COVID-19, major online brokers saw new accounts grow as much as 170 percent in the first quarter of 2020.1 For investors, whether working with an advisor or taking a DIY approach, it’s important to understand the fundamental differences between two most common investing practices - active and passive and the advantages of the third, evidenced based investing. Investment vehicles that pursue cost effective exposure to globally diversified strategies include:
- Mutual funds
- Exchange-traded funds (ETFs)
- Portfolios of stocks, bonds and other holdings
What Is Active Investing?
Some investors may look at active investing with a goal of “beating the market” and outperforming specific standard benchmarks. In order to do this, investors engage in proactive trading, buying or selling as prices rise and fall.
The general idea surrounding active investing is that if things go well with your investments, you may be able to outperform the market, even after the higher fees you pay. Performance, however, is never guaranteed.
Active Investing Considerations
Active investors attempt to beat the market by engaging in speculative strategies trading individual stocks or sectors of the markets.
Fees vs. Performance
Typically, actively managed portfolios can incur higher fees than those who follow a passive investment strategy. Because of this, an investor would want to beat the market by a certain percentage in order to make paying the higher fees and taxes worth it in the long-run.
What Is Passive Investing?
Passive investing buys and holds securities to track a particular index.
These funds typically rise and fall matching the performance of particular benchmarks. Because of this, passive investments are not meant to beat or outperform the market, but rather mirror the index’s performance.
Passive Investing Considerations
Potentially Lower Fees
Because passive funds don’t have such a hands-on human component to them, they tend to incur lower fees than active investments.
An investor will know exactly what stocks or bonds their indexed investment contains. For some, this transparency and consistency may be comforting or reassuring to know as they work toward their long-term financial goals.
With the lower fees and tax efficiency, passive investments tend to be an appealing option for investors who don’t have the time, skill or desire to actively manage their investments. However, while index investing has its advantages it also has many drawbacks.
A Better Option
Evidence-based investing seeks to improve on index investing's best traits and minimize its weakness. At its core it is a rules based strategy that incorporates available financial science on how markets have rewarded long term investors instead of blindly tracking popular indexes. It reduces the need to place undesirable trades at inopportune times simply to track an index. It allows a more patient trading strategy and scales of economy to achieve better pricing and maximize the factors we can expect to control. This includes most effectively capturing markets’ expected returns, while aggressively managing for market risks, minimizing trading costs and tax consequences while dampening some of the noisy volatility along the way.
How you choose to invest will likely come down to your unique situation; it is important that investments be structured in a manner that is consistent with your goals, risk tolerance and economic conditions. If you’re unsure what direction to take your investments, an investment advisor can help explain your options and provide further guidance.