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What is Active Passive Investment Strategy?

A quick guide for beginners on active and passive investment strategy.

Just getting into investing, you most probably would have heard of this battle that has been going on over the aeons, to be active or to be passive? Which is better? Should you invest actively or passively?

What is Active and Passive Investments?

Active Investment Strategy:

An active investment strategy is where investors actively manage their investment portfolio. The active investment approach takes a more hands-on-deck approach where investment managers constantly monitor the market, as well as conduct research and analysis to look for any opportunities to buy or sell assets so that they can make a profit from price fluctuations.

 

Note: For people who can’t afford to spend their waking days monitoring the stock market, they would usually appoint a fund manager to manage their investments.

 

The most common goal among active investors is that they seek to beat benchmarks, which are usually market indices such as the S&P 500 index, Dow Jones Industrial Average (DJIA), Nasdaq, and more. This is different from the passive investment approach which aims to follow benchmarks’ performances (we will get more on that later). 

 

In terms of ‘beliefs’, active investors believe in something called “investors’ irrationality”. Investors’ irrationality refers to the concept that the price of stocks in the market does not reflect its true value because of irrational overall investors’ behavior.

 

What it essentially means is that the stock prices you see on the market may not actually reflect the value of the company. Why? Because these prices are influenced by investors’ behavior that is susceptible to irrationality like biases, emotions, greed and so on. This is different from the belief usually held by passive investors (which again we will explain later). 

 

The result of this belief is that active investors embark on the journey to search for these actual values to make a profit from them. Say, Stock A’s current price is $100, but upon analysis, they deem it to be worth more, say $150, then they would buy it in anticipation that the price may rise to the actual value.

 

In terms of time frame, active investors usually look to make short-term profits rather than longer ones. 

Passive Investment Strategy

The passive investment strategy is where investors take the approach of spreading their money over many stocks (diversification), and not looking for the ‘hidden gem’ stocks, but rather they look to make sure that their investment performance can perform as good as the benchmarks, like market indices (S&P 500 index, DJIA, Nasdaq, etc.). 

 

There are generally three ways that investors invest passively:

  • Index Investing: Where investors invest in funds that can replicate the movements of a market index.
  • Direct equity: Where investors bundle up individual stocks that can perform close to the benchmark.
  • Exchange Traded Funds (ETFs): ETFs are like any other fund, where a bunch of people pool their money, and the money is then used to invest in certain assets – only that ETFs itself is bought and sold in the stock market. It’s not like the usual funds where you have to go to the fund issuing company and deposit your money there.

 

In terms of ‘beliefs’, passive investors usually hold on to the Efficient Market Hypothesis (“EMH”), where it’s the concept that consider all the prices of all stocks in the market have reflected all the information available to the market. Simply put, if you see that Stock XYZ is at $20, then that $20 is the fair reflection of all the information related to Stock XYZ which is available to everyone in the market at the moment.

 

As for the time frame, passive investments usually look to make long-term profits. Short-term profits in passive investments are not impossible, but usually, the portfolio moves at a slower pace, thus making profitability over a short-term relatively lower.

Which one is better?

Of course, it will all go back to the ultimate question of “which one do I pick then,” and on our part, apart from legal reasons, we are bound to tell you that it is up to you – and we really mean it. 

Why? Because it is your money. Your income is different from other readers, your monthly allocations are different, your risk tolerance is different, and your goals are different, so yes – it really is up to you.

But here are some comparisons so you can make up your mind better.

Comparison:

*With regards to the statement that passive investments produce lower returns, there are a few pieces of research that show active investing actually provides fewer returns over a certain period. However, it is still an area of ongoing debate, some dispute the methods and data used in the research.

Pros & Cons:

On a side note, the strategies that you can choose from aren’t binary. You can have hybrid strategies that combine both active and passive approaches such as Smart Beta strategies, etc.

Bottom Line

  • Choose a method that suits your personal goals, risk tolerance, and financial capabilities.
  • Make sure that you take into consideration the overall cost of investing, such as management fees, commissions, tax, spreads, and others.
  • If you’re investing by yourself, it’s better to try and make a long-term profit, unless you can afford to go for day trading.
  • Make sure you are free from bias and emotions in choosing your stocks/funds /fund manager. Never let yourself get catfished in putting your money somewhere… *sobs* how dare you Julia.
  • Try to diversify your portfolio to make sure your exposure to risk is tolerable.

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None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.

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