You might see the words ‘active’ and ‘passive’ when reading about investing. Both are key to understanding the investing landscape, but choosing which strategy to pursue has long been a clash in finance circles.
Justin Fox, author of "The Myth of the Rational Market," explains the difference between the two. "Active investing is what people think of traditionally as investing. Someone picks the stocks that he or she thinks are gonna go up," Fox says. "That’s what most mutual-fund managers and hedge-fund managers and all the rest [do]."
Passive investing instead takes choosing stocks out of your hands. "Passive means you just sort of decide ahead of time either maybe you’re gonna own all the stocks in S&P 500, or it can be any sort of thing you set up ahead of time, and then you just leave it, or maybe you have automatic adjustments," Fox says. "But the idea is you’re not making conscious decisions every day."
So which approach should you take with your own money?
"The argument for active investing is that either you or someone you can choose knows better than the market where the market is going. Part of the issue is, some people do. There is actual skill in investing … and sometimes are successful over pretty long periods of time in outperforming the market," says Fox. "As an individual, the big advantage is that you’re not a mutual-fund manager, you’re not having your performance checked every quarter, and not getting fired if you’re way behind the S&P or some other index. You could in theory stake out sort of unique investing strategy."
The problem, Fox notes, is that most people just aren’t capable of doing that very well. Someone can beat the market for a year or longer, but it can be difficult to tell whether or not an active investor is the reason for that success. "It’s very hard to tell someone’s past performance is luck or just skill," Fox says. "The biggest danger anytime the market is moving around a lot is that it’s gonna make some active investors [look successful], when all they are is reckless or lucky or both. In a time of volatility is gets harder to judge whether an active investor knows what they are doing."
One benefit that passive investing has over active investing is that it’s usually cheaper. Fees for actively managed funds can get expensive, which over the long-run can eat away at potential investment gains.
"The whole point of an index fund is that it should be super super cheap, and they should charge you a way lower percentage to manage your money, Fox says. "If as a whole your active money managers are gonna just track or slightly trail the market, and your index funds are going to do the same thing, but your index funds are charge maybe a percent less per year to do that, you’ve come out way ahead."
FINRA has a great calculator that allows you to compare funds and see how fees can impact your investment. For example, let’s say you invest $10,000 into two funds that are both expected to make 8 percent per year. One fund charges 0.2 percent per year, the second fund charges 2.25 percent annually, plus a 5.75 percent fee on your initial investment. According to investment website BogleHeads, the difference between the two funds over 30 years will add up to $44,753.
"If you’re just starting out and you don’t know where to go, you gotta start with index funds. I know we all think we’re above average and the like, but I think with investing it is possible to be honest with yourself," Fox says. "I’m somebody who started out … buying individual stocks. Partly out of personal experience and partly spending a lot of time researching financial theory, I finally realized it’s just dumb. Somebody can do that well, but it’s not me."