When most laymen think of investing in the stock market, it brings to mind reading charts, forming strategies and making trades at just the right time – the kind of trading you need an online trading platform for, unless you get a broker who actively manages accounts. Indeed, much trading is done this way. However, this method, active trading, is not the only investment strategy, and in many cases, is not the best strategy for growing your investments.
There's also passive trading, also known as indexing, in which a broker does not endeavor to guess the market's next move so much as to mimic the already existing moves of an established index like the Dow Jones or the S&P 500. The broker follows the same methodology used by the index when constructing the portfolio. The passive portfolio then rises and falls like the index.
Increasingly, passively managed investments have consistently outperformed actively managed funds in most areas. Only 12 percent of active U.S. large-cap growth funds, for example, beat passive peers over the last decade, according to Morningstar's Active-Passive Barometer.
Further, active investors who beat the market one year have only a 20 percent chance of outperforming the index a second year, and just a 10 percent change of outperforming it three years in a row, according to Wharton Professor of Economics Kent Smetters.
Despite this, there are advantages and disadvantages to both systems. There are also times and places where one works better than the other.
Advantages & Disadvantages of Passive Trading
Passive trading has consistently earned better returns than active trading in recent years. The reasons it has the advantage include the following:
- The U.S. market is relatively transparent and efficient, which means the best stocks rise to the top and become part of the index.
- Because brokers or account managers don't have to spend as much time or energy following the market, commissions are much lower. Commissions on index funds average .11 percent, while mutual funds average .84 percent.
- You don't depend on a broker's experience or education.
However, there are some disadvantages to relying solely on passive trading:
- You cannot customize your portfolio.
- You cannot enact changes to take advantage of market shifts.
- Your passive portfolio will never do better than the index it's based on.
- You are at the mercy of the market. If it falls, you will lose money.
- You're investing in whatever company is on the index, whether you approve of it or not.
Advantages & Disadvantages of Active Trading
Active investors strive to do better than the index market, so when they do well, they can be highly profitable. Having an expert investor guiding your portfolio has some advantages, including:
- In unstable or risky markets, they may know how to take advantage of fluctuations.
- They can do well in niche markets or in choosing small company stocks that have not made the index, because brokers use their experience to spot potential.
- When a market is falling, you can adjust your portfolio to take advantage of the changes.
- Active brokers know which stocks to sell in order to offset the taxes you'll pay on winning investments.
- Active trading lets you invest your money in companies you believe in.
However, there are some risks to active trading, such as:
- You depend on the skill and knowledge of your broker. Check the track record of your broker before signing on.
- Higher fees. Because you are paying for the broker's knowledge, skill and research time, fees are higher. Better brokers charge even more.
- Overall, actively managed portfolios are not faring as well. Unless the market changes drastically – and we've seen both recession and recovery in the past decade – there's not a lot of reason to think actively managed investments will suddenly do better than passively managed ones.
Active vs. Passive Investing: The Best Investment Portfolio is a Mix
Investors have come to realize that passive investing is the most secure route, but the lure of big returns is often what draws them to the market in the first place. Therefore, almost 60 percent of investors say they prefer a combination: passive management for broad market investments that provide a surer base balanced with actively managed funds that focus on narrower market segments with high growth potential.
The proportion of active to passive depends on your personal preferences – whether you like the safe road or enjoy the gamble – your age and your goals. As always, be prepared to lose everything. There are no guarantees in the stock market, no matter which way you go. Nonetheless, intelligent investing can help you secure your financial future. Good luck and good investing.