Active and passive investing has been debated for years on which investment style provides a better return. Active investing is an investment strategy involving ongoing buying and selling actions by the investor. Active investors purchase investments and continuously monitor their activity in order to exploit profitable conditions (investopedia.com, 2010). In order to be an active investor, investors need to be highly involved. This often means checking price movements of investments multiple times throughout the day. Typically, active investors are seeking short-term profits from the market through constant price fluctuations. On the other hand passive investing is an investment strategy involving limited ongoing buying and selling actions (investopedia.com, 2010). Passive investors are looking for long-term appreciation and limited maintenance, they are not looking to profit from short-term price fluctuations like active investors. Instead they believe their investments will be profitable in the long-term.
So as we can see both investment strategies are viable options depending on the investor's goals. Active investing usually involves riskier stocks as these stocks fluctuate often in price, which allows investors to buy and sell at optimal times in order to earn a profit. Passive investing usually seeks out long term limited risk investments. These may include well-established companies like GE or Microsoft or long-term government securities that bear little risk and return annual profits.
For the most part many of us who invest par take in some form of active investing. Meaning we invest at a time when we feel we can maximize our portfolios based upon our investments. For example, I recently purchased shares of Ford Motor Company based on the fact that the stock had dropped considerably and I felt that it would increase in the months to come. This is an example of value investing. Investing like this involves stock picking and market timing in order to maximize profits. As an investor you need to actively pursue stocks that you feel will see considerable gains in the near future or are currently undervalued. When we use market timing to choose investments we are looking to shift money in and out of different investments to profit from short-term price fluctuations. Much of the money managed by stockbrokerages, trust companies, and individual investment advisors use an active investing approach. Many of us also utilize a passive investment style. Passive investing often involves investing in index mutual funds and/or asset class funds. The manager of an index mutual fund or asset class fund seeks to capture the long-term performance or return of the targeted index, which tracks the fund or asset class. For example, if an investor is happy to mimic the S & P 500's performance he will buy shares of an indexed mutual fund. With this purchase the investor is trying to receive the annual 8-10% that the S & P sees annually. The objective of passive investing is to match the market return. Since this objective is much more reserved and attainable, many investors seem to think passive investing is a much safer bet than active investing (morningstar.com, 2005).
Some people seem to think that active investing is only as good as the manger in charge of it. For decades, academic finance has been trying to teach us something important: If the "average" portfolio manager in an asset class charges higher fees than the index (and most do), the "average" manager will deliver net investment performance worse than the index. Why? By definition, the "average" return in an asset class is the performance generated by the blend of all the assets in that class before fees. Active management is only better when a manager can clearly demonstrate consistent out performance, net of fees (Wagner, 2010). Many experts seem to believe that passive investing is the best option for investors as it has been proven to outperform active investing with much lower fees. Given that there are thousands of stock market experts, mutual fund managers, private money managers, and advisors, some will make spectacular calls and accurate predictions. Yet, extensive research has shown that, as a group, the performance of experts is what would be expected from chance guessing, there is no way of knowing in advance who will make the right call, and past successes is not an accurate indicator of future performance. Active investors must overcome many costs to match the returns of the average passively managed portfolio. These include trading costs, much higher management fees. Because of increased costs and risks, about 75% of active managers, as a group, under perform passive portfolios during any given year and, over time, this percentage increases until only a few outperform market averages. When matched for asset type and mix, passive managers outperform active managers by about 2% per year, on average (evansonasset.com, 2007). Since active investing attempts to choose securities or investment vehicles that outperform the market they often concentrate their intuitions on specific areas. Whereas passive investing tends to diversify much more which helps eliminate some risk. "Further, research has shown that diversification itself produces higher returns with lower risks than simply investing in one or two investment categories" (evansonassets.com, 2007).
With all this being said is there any advantage to active investing? Can active managers provide value beyond passive management by taking advantage of arbitrage and market anomalies? They answer is yes, but it has become extremely difficult to profit from mispricing in the market. Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms (investopedia.com, 2010). With the advancements in technology it is becoming almost unheard of to profit from arbitrage because most all traders have computerized programs that alert them when a stock is mispriced. This has ensured that these stocks are gathered up swiftly thus limiting the opportunity.
From what I have read and researched active investing is not the way to go. Active investing attempts to "beat the market" and with the unpredictability of the financial market it makes it extremely risky and difficult to achieve this. Passive investing on the other hand tends to stick to an index or asset class such as the S & P. Markets such as these have shown a consistent return and investors attempt mimic this. I feel that passive investing is a much better option than active investing as it diversifies and helps alleviate as much risk as possible. Active investing is not always bad but I wouldn't wrap my whole portfolio in it. Taking risk often means large rewards which is they case with active investing. A person with a well-diversified portfolio can actively invest a small portion of his/her capital in active investments hoping to beat the market.
