When it comes to investment management, there are two main philosophies: active investing and passive investing. You may be thinking: “Why choose a passive investing strategy? Wouldn’t I want to stay actively involved and ‘on top’ of my investments?!” Of course you do. But it doesn’t have to be done through a time-consuming, expensive, and tax-inefficient strategy (hint: these are common traits of active management).
Below, we’ll explain the concepts of active and passive management as well as 6 reasons why adopting a passive investment philosophy is the preferred option.
A closer look at active and passive investing philosophies
There are two basic styles of investing: active management and passive management.
What is active investing?
Active management is a practical investment approach consisting of investors looking to beat a specific market index (or benchmark) through targeted investing, market timing, and any number of strategies that seek to achieve above-average returns.
As an active investor, you may have lots of individual common stocks, actively managed mutual funds, or active exchange-traded funds (Even to a lesser extent) within your investment portfolio. Actively managed funds are funds managed by portfolio managers who select investments that seek to outperform the benchmark. You can also use more alternative investments, such as private equity and hedge funds.
Through active management, investors have a strong belief that skilled portfolio managers can outperform the market by taking advantage of price movements, market conditions, and events (more on how to do this later!).
What is passive investing?
While the active management approach looks to outperform a particular sector of the market, the passive management philosophy consists of investors only trying to capture market returns while keeping investment costs low.
A passive investor’s investment portfolio may consist of passively managed index funds and/or ETFs.
A passive investor has little interest in profiting from short-term market movements or specific market events (i.e. market timing) and instead believes in the potential for long-term investing over an extended period (i.e. buy-and-hold strategy). . This is reflected by replicating the investment results of the target index by holding all securities in the index or a representative sample of them.
A passive investing strategy operates on the assumption that long-term market efficiency will lead to optimal results.
6 main reasons to adopt a passive investing approach
If you’re an avid user of the NewRetirement Planner, you may be a DIY investor who fully understands the benefits of a passive investing strategy.
However, if you are still undecided about your investing beliefs or are looking for more ideas, here are 5 reasons why many investors choose a passive approach rather than active management.
1. Passive investments cost less
As the names suggest, an active investor tries to beat the stock market while a passive investor believes that the markets are efficient and tries to capture the returns of a particular sector of the market. Passive funds do not have human managers making decisions to try to beat the stock market. With no paying managers, passive funds generally have very low expense ratios.
Although fees for actively managed funds have declined over time, index funds and passive ETFs are still the winners here according to Investment Company Institute 2023 Investment Company Factbook. In 2022:
- The average expense ratio for actively managed stock mutual funds was 0.66%.
- The average expense ratio for stock mutual funds is 0.05%.
- The average expense ratio for equity ETFs was 0.16%.
Although the gap between 0.66% and 0.05% may seem small at first glance, it can increase over time.
Let’s look at an example:
- You invested $25,000 in an actively managed stock mutual fund with an expense ratio of 0.66%
- I also invested $25,000 in an index stock mutual fund with an expense ratio of 0.05%.
- Both funds returned 7% annually for 20 years
- The low-cost index fund is worth about $95,842
- The highest cost actively managed fund is worth about $85,482, or $10,360 less
- This difference will also double over time, with the index fund worth about $29,590 with 10 additional years of growth.
When it comes to investing, it pays to be passive!
2. You can get better returns
For many investors who don’t already have a strong investment philosophy, active management may seem like a promising approach. After all, who wouldn’t want to invest in better performing funds and stay away from underperforming funds?
However, attempts to time the market, select individual stocks, or assemble the perfect mix of actively managed mutual funds often fail to achieve desired investment results. Most professional fund managers who engage in active trading of stocks or bonds often fail to achieve better returns than the index they are trying to beat.
Since its initial release in 2002, SPIVA Scorecard It has served as a scorekeeper in the long-running active versus passive debate. Here are some stats from the scorecard:
- In 2023, 75% of active U.S. equity funds underperformed their benchmarks
- In 2023, 68% of active international equity funds underperformed their benchmarks
- Over a 20-year period, 96.83% of all active US equity funds underperformed their benchmark (S&P Composite 1500) on a risk-adjusted return basis.
While active managers can indeed outperform the market from time to time, these periods of high returns are often short. This makes it difficult not only to identify high-performing managers, but also to find those who consistently outperform over time. In addition, leading managers can change over time as well.
3. Passive investing can reduce stress and increase financial confidence
Life can certainly have stressful moments. Your investment strategy should not add to this stress.
Passive investing, with its “set it and forget it” approach, provides a significant reduction in stress and an increase in financial confidence for investors. Once you select a few index funds or ETFs and are comfortable with your asset allocation, most of the hard work is done. From a long-term perspective, minimal intervention and oversight are needed moving forward.
By letting go of the constant need to monitor market fluctuations and make repetitive trading decisions, passive investors can enjoy a sense of calm and stability in their investment journey. Instead of worrying about timing the market or responding to short-term fluctuations, passive investors can focus on their long-term financial goals with a clear mind.
By embracing the fact that markets are efficient, you realize that a long-term, globally diversified, low-cost passive portfolio provides a more relaxed and calm approach to investing.
4. Want to lower your tax bill? Stick to passive investing
Taxes play a role in many areas of your money, including your investments. When it comes to investing in taxable accounts, a fund’s tax efficiency can significantly impact the after-tax performance of your investment portfolio.
Actively managed mutual funds often come with a high turnover rate due to frequent portfolio management decisions. Turnover is the percentage of a fund’s holdings that were exchanged in the previous year, resulting in a taxable capital gain. For example, a fund with a turnover of 100% will have an average holding period of less than one year.
Meanwhile, the passive investment strategy of mutual funds and ETFs with built-in tax efficiency can reduce the tax burden on your returns. These funds are often more tax efficient than active funds because they typically have lower turnover rates. The buy-and-hold approach to an index fund results in fewer taxable events and often minimal, if any, capital gains distributions. ETFs may offer an additional tax advantage: ETF redemptions sometimes allow ETF managers to adjust to market changes without selling portfolio securities directly (saving capital gains taxes).
As an investor, you should strive to minimize these tax costs and performance lag wherever you can. Use the NewRetirement Planner to review your potential federal and state tax burden in all future years and get ideas for reducing these expenses.
5. It requires a negative approach less time
Time is the most precious thing you have, it is limited and cannot be replaced. Given its value, it is important to use it wisely. Investing can be as simple or complex as you want. It can save you time or it can take up a lot of your time, depending on your investment strategy.
Following an active investing philosophy can come with significant opportunity costs. There can be a lot of time and effort put into your actively managed portfolio with many questions to think about such as:
- What’s your next step when part of your investment portfolio goes through a period of underperformance?
- If you sell certain funds, what funds will you buy next?
- If you buy into funds that have performed well recently, how do you know they are not the next funds that will underperform in the next 10, 3, 5, or 10 years?
- Or perhaps you are planning to hold cash to “weather the storm,” when do you feel is the best time to return to the market?
- If you feel good about certain funds and their portfolio managers, when do you think they will turn things around if they underperform? Or will they ever?
As you can see, these types of questions can affect you not only from a temporal perspective, but they can have an emotional impact as well. Along with this, you also have to research hundreds (if not thousands) of mutual funds and individual common stocks, which is a big commitment in itself.
Meanwhile, with passive investing, you can pick 1 to 3 index funds or ETFs and set it and forget it, with some rebalancing along the way. One of the few key decisions you need to make as a passive investor is to select the right mix of stocks and bonds (eg 60% stocks and 40% bonds) to align with your financial goals and risk tolerance. It’s much less time consuming than the buy, sell, and market timing questions and decisions that often come with investing in actively managed mutual funds, private equity, and hedge funds.
Note: Spend less time managing your investments by adopting a passive investing philosophy and focus more on planning for your future retirement with the NewRetirement Planner.
6. You can reduce risk with a globally diversified passive portfolio
Diversification is an essential component of an overall investment strategy.
Because passive strategies often focus on index funds or ETFs, you’re typically investing in hundreds, if not thousands, of stocks and bonds. This allows for easy diversification and reduces the risk that one very weak investment will dramatically impact your entire investment portfolio.
Just two or three index funds or ETFs can provide you with a low-cost, globally diversified portfolio that can meet your retirement savings goals.
On the other hand, if you approach active investing on your own without proper diversification, a few bad choices or actively managed funds can wipe out big gains in your portfolio. Building a globally diversified portfolio through active management can be time consuming and expensive, requiring a lot of effort and potentially high fees.
You can save time and money with passive investing and a new retirement planner
Although investing is a very important component of building long-term wealth, it is not the only consideration.
Use NewRetirement Planner to build, track and manage all aspects of your comprehensive financial picture: investments, recurring expenses, medical costs, long-term care, real estate, and more. The tool can play a vital role in helping you make informed decisions about your strategies and their impact on your financial security now and in the future.
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