Investing comes in many shapes and forms, from trading foreign currencies to underwriting options contracts. But you can also approach it in one of two ways – active versus passive investing. Knowing which type of investor you are can help you make more sound strategic decisions later—everything you need to know about these two very distinct investing styles.
What is Active Investing?
As the name implies, active investing involves a higher frequency of trades with the primary objective of outperforming average index returns, such as the S&P500. Active investors are best depicted in Wall Street’s traders, who are known to buy and sell assets at large volumes and higher frequencies. Actively investing can also be referred to as trading or speculating since you are trying to predict the future price of an asset with financial analysis and relevant tools.
Since you are trying to foresee what is going to happen in the future, whether it’s a minute from now or a year from now, active investments come with a higher level of market assessment to evaluate the best position to take at any given time. So, for example, what investment vehicle to purchase, how long to hold a position, and whether to take a bullish or bearish stance.
Pros and Cons of an Active Style of Investing
Because active investors buy and sell investment vehicles, such as stocks, currencies, options, and futures, intending to close the position within a comparatively short time frame. They can capture short-term gains that long-term or passive investors cannot capture. And thanks to companies like SoFi, active investors can now trade without paying hefty commissions when opening or closing positions.
But this more significant profit potential also comes with a higher risk of capital loss. Since you are constantly changing your market bias, you could buy when you’re supposed to be selling and sell when you’re supposed to be buying.
What is Passive Investing?
Passive investing, also known as long-term or index-style investing, is buying and holding stocks, bonds, or any other investment vehicle for an extended period. Investors typically go for indexed mutual funds and exchange-traded funds that track broader markets whenever they are building a passive-style portfolio.
Pros and Cons of a Passive Style of Investing
Passive investing entails fewer trades or buy/sell orders, which means lower transactional fees. Since you buy baskets of stocks or bonds, you also save on financial services as there is no need to analyze specific securities. Another pro of passive investing is tax efficiency. A buy-and-hold approach means that you do not need to worry about incurring hefty annual capital gains taxes.
A drawback to passive investing is that you cannot profit from the short-term fluctuations in market prices. In addition, you typically need a large investment account for the returns to be worthwhile over the long run.
No one style of investing fits everyone; you’ll have to determine that based on your investment goals, risk profile, and available capital.