What's the difference between active investing and passive investing? | Pearler (2024)

We see you there, brimming with ambition and eager to get that bread. But as you explore the world of personal investing, you stumble upon two terms: active investing and p assive investing . Cue curiosity and confusion!

In this article, we'll focus on answering the question: "What's the difference between active and passive investing?”. At Pearler, we advocate passive investing, but we also respect that every investor has their own style. So, let's take a closer look at the options and help you make a smart call on how to grow your wealth.

What is passive investing? The slow but steady sail to wealth

On one side of the investing spectrum, we find passive investing. This is the strategy most Pearler community members embrace. Passive investing takes a relaxed approach. Think of passive investing as embarking on a cruise ship—a large, reliable vessel that slowly sails you toward your financial goals

Passive investors believe in diversification and riding the long term wave of market growth. They spread their investments across low-cost index funds and exchange-traded funds (ETFs) and hold on for the ride.

If you embrace the simplicity and reliability of the market, passive investing might be for you. It's a strategy favoured by those who believe that the sharemarket, as a whole, is hard to consistently outsmart. If you're a passive investor, you get to spread the risk around, save on costs, and avoid a lot of stress. You can focus on other areas of life while your investments grow over time.

What is active investing? A symphony of strategy and sweat

Active investing can be like a high-stakes game. Adrenaline rushes and excitement are part of the package. Active investors often commit a lot of time to being really good at what they do. They want to beat the market and hit it big by buying when things are cheap and selling when they're expensive.

Active investing has its shining moments. Its proponents have the freedom to cherry-pick individual shares and spot undervalued assets. Active investors love the thrill of digging into research, crunching market data, and catching the perfect moment to make a trade. They employ sophisticated strategies to take advantage of market inefficiencies.

However, the journey to success in active investing can be challenging. This approach demands significant time, effort, costs, expertise, market timing, and luck.

Examples of passive investing

Passive investing lets the combination of time and compound interest work its magic.

Here are a few examples of passive investing strategies:

Index funds

These funds are a hit with people who just want to sit back and let their money do the talking. They copy a market index, like the ASX 200 or S&P 500, so you get a piece of the pie no matter what. It's like getting a taste of everything with very little work on your end.

Exchange-traded funds (ETFs)

Investing in ETFs is a low-cost and tax-efficient way of getting in on certain markets, regions, or even specific niches or themes. ETFs offer flexibility and are easy to sell, all without trying to beat the market. While they're technically different assets, many investors use the terms "ETFs" and "index funds" interchangeably.

Buy and Hold

This timeless strategy involves buying a diversified portfolio and holding onto it for the long haul. Patience is the name of the game, allowing compounding and market growth to fuel your wealth.

Dollar-Cost Averaging

Passive investors understand that markets can be unpredictable, so they take a methodical approach. They invest a set amount at regular intervals, no matter what's going on in the market. As a result, they pocket more shares when prices are low and fewer shares when prices are high. The idea is that, eventually, their acquisitions will balance out to an average purchase price.

Examples of active investing

With active investing, it's all about staying on top of the market's every move.

Here are a few examples of active investing strategies:

Stock picking

The stock picker dives headfirst into the vast ocean of individual shares. They analyse financial statements, assess market trends, and make calculated bets. Active investors believe they can uncover hidden gems that will skyrocket in value.

Timing the market

The pursuit of perfect timing is no easy feat. The ambitious market timer attempts to predict the perfect moment to enter or exit the market. They may jump in when they perceive the market to be at a low point, then pull out when they believe their shares have peaked.

Actively managed funds

Tactical asset allocation

Active investors may try to make some quick profit by changing their portfolio based on short term trends in the market. It's akin to catching the waves of the next big thing and surfing them to success.

Comparing the two investing approaches

In one corner, we have active investing, where you can find the thrill seekers and market enthusiasts. They spend their days monitoring stocks and making rapid-fire decisions like they're playing a game.

On the other side, we have passive investing. The calm and steady strategist prefers the simplicity of mirroring the market's history of growth.

So, which approach should you choose?

Ultimately, the choice is yours to make. It all depends on factors including risk tolerance and personal enjoyment. We present the pros and cons below with the intention of helping you make an educated decision.

Active investing advantages

• Potential for higher returns
  Skilled active investors have the potential to outperform the market during favourable conditions.
  
• Flexibility and control
  Active investing gives you the freedom to make quick changes to your portfolio and capitalise on emerging trends or events. Active investors can handpick individual investments according to their preferences and convictions.
  
• Intellectual stimulation
  If you're into finance, the exciting ride of active investing might be worth the risk. You get to do all kinds of analysis and make some big decisions.

Active investing disadvantages

• Higher costs
  One significant difference between active and passive investing lies in the fees involved. When you buy actively managed funds, you're basically paying the fund managers for their skills and frequent trading. You should know, though, that this comes with a lot of fees. These costs can reduce your investment returns and your ability to make consistent gains. Active investors who pick individual stocks (rather than funds) will also likely pay higher fees via more frequent brokerage costs.
  
• Time commitment
  Successful active investing requires significant time and effort. The buy low, sell high strategy means you need to keep an eye on things all the time, even when the market's closed.
  
• Much higher risk
  With passive investing, you only need to hedge against market risks such as the economic cycle or interest rate changes. By contrast, active investors take on both the challenge of market risk and another type of risk. In investing terms, it’s called firm-specific risk .

  When actively investing, you're trying to predict the short term changes in the price of both the overall market and a company's shares. Even the pros have a hard time getting it right because of too many factors at play. And if you try too hard to time your investments, you could end up making costly mistakes.

• Emotional investing
  Sometimes active investors get all caught up in their feelings and start making bad decisions when the market is down. As a result, their roster of shares might end up doing worse than the rest of the market.

Passive investing advantages

• Lower costs

  Passive investing has lower fees because it involves fewer transactions and just goes along with the growth of the market.
  

• Long term stability

  Historically speaking, the longer passive investors have waited, the more their investments have typically grown. This is thanks to the compounding effect . It's for folks who want stability and reliable growth over the long haul.
  

• Simplicity

  If you're not into spending all your days watching the stock market, passive investing might be for you. It's a "set it and forget it" approach. You don't have to babysit your investments every day, so you can spend your time pursuing your hobbies and passions.

Passive investing disadvantages

• Market returns Passive investors aim to match the market, which means they won't outperform it. If you're seeking to beat the market, passive investing may not be your tool of choice.

  However, recent research has shown that passive investing can actually give you higher returns than actively managed funds - even in troubled markets. It’s worth keeping in mind.

• Lack of control Passive investing entails relinquishing control over individual stock selection and timing. You'll ride the ups and downs of the market, which demands maintaining a philosophy of building wealth slowly.
  
• Limited customisation Passive investors have less control over the composition of ETFs that track a predefined index like the ASX 200 or the S&P 500.

  Yet, many passive investors have ways to balance their exposure to broad markets or indices. They often achieve this with ETFs that zoom in on specific trends or themes. Sustainability ETFs , for example (also known as ESG ETFs), make investing a force of good in areas of social, environmental and governance impact.

• Emotional test The wild swings of the market will test your patience and discipline. It can be emotionally difficult to stay the course and resist the urge to make knee-jerk reactions. A strong purpose for investing and remembering your destination can protect your peace of mind.
  

Can you blend active investing and passive investing?

Now, don't think it's a battle royale between active and passive investing. In reality, there's room for both in your investing toolbox.

Sometimes, you might want to sprinkle some active investments into your passive portfolio, like adding a dash of hot sauce to your meal. This is popularly known as the “core/satellite” approach .

For instance, you can allocate 5-10% of your portfolio to individual shares that you truly know and believe in. This allows you to satisfy your itch for adventure while keeping the majority of your investments on the passive path.

Why Pearler prefers passive investing

We said it at the beginning of this article, but for transparency, we'll say it again: at Pearler, we're Team Passive Investing.

Our Pearler community members prefer passive investing for three main reasons.

Firstly, it tends to have lower fees and transaction costs, which means more money stays in your investments. Secondly, it generally offers broader market exposure, reducing the added risk specific to a company or industry. Lastly, it's easier to stick to a long term plan without the stress of constant decision-making. There’s more to life than looking at charts all day and worrying about your next stock picks.

While we believe in the power of passive investing, we also believe in the power of choice. We encourage you to do your own research on both approaches and select the path that resonates with you.

Remember: investing should align with your financial situation, goals, skills, and risk tolerance. Whether you choose one approach or both, what matters most is making a conscious and informed choice that puts you on the path to financial independence.

Happy investing!