When creating an investment strategy, it’s important to know how passive investing or active investing could work for you.
Depending on your goals, time horizon, and comfort levels, you may come to favour one over the other. Here are a few important points that could help you figure out if either approach may be right for you.
What’s passive investing?
Passive investing has increased in popularity in recent years as app-based investment platforms have become more available. Passive investing is generally speaking a strategy defined by its minimal buying and selling of stocks or other instruments.
Instead, passive investing can be considered a ‘buy and hold’ strategy with a long term investment horizon. A common form of passive investing involves investing in diversified products like exchange traded funds (ETFs) that track major indices (like the S&P 500 or Nasdaq) over a longer period of time.
As the value of these diverse products increases or falls, so too would that of your holdings. Passive investing allows for a more hands off approach to wealth building, and historically can perform well over many years.
What’s active investing?
Active investing involves the active management of a given portfolio. You could be the one managing the portfolio, or it could be a financial advisor or portfolio manager that you hire to manage your investments on your behalf. It is the job of the active investment “manager” to try and maximize the value of the investments in the portfolio by using highly specialized knowledge and intuition to buy or sell.
Where passive investing is about taking a hands-off approach over a long period of time for generally more moderate returns, active investing is about taking a hands-on approach over shorter periods of time in the hopes of securing some big wins or gains in the value of your portfolio due to timely opportunities and price fluctuations.
Active investing typically involves higher fees than passive investing, in part because you are paying a fee to your investment manager, and because there may be a cost associated with executing trades.
Pros and cons of passive investing
Passive investing has been theorized as a good option for most casual investors because it will typically involve lower fees and less risk. However, passive investing does have a few disadvantages you should consider, too.
- Low fees. Because of the lower trading volume typically involved in passive investing, and because no dedicated portfolio manager is required, passive investments can cost much less than active investing. PWL pegs the management expense ratio (MER) of passive funds in Canada at just 0.28%. This can make a huge difference in your returns over time.
- Tax efficiency. Because passive investments may grow more moderately (when compared with active investments), you may avoid larger capital gains taxes.
- Lower comparative risk. Because passive investments often track well established indexes like the S&P 500, while the value of your investments will certainly fluctuate over time, their diversification tends to limit the volatility compared to individual stocks.
- Slower growth. Passive investing isn’t about trying to win big in the short term. Instead, this strategy could be conducive to saving for retirement, for example, where over the long term your regular contributions and returns could steadily accrue. However, this means its goal is not to see big gains in short periods of time.
- Market underperformance. According to some, once costs are taken into account, passive investments that simply track a market index may underperform the market (because they track the market itself).
Passive investing may be a good strategy for you if you plan to invest over a long period of time, if you aren’t chasing big wins in short periods, and if you want to keep your costs low.
If passive investing sounds like it could be right for you, check out the Moka app.
Moka rounds up the spare change from every purchase you make and invests it weekly in diversified portfolios. Plus, you can give your savings an extra push using roundup multipliers, recurring deposits and one-time boosts, all of which will get automatically invested.
Getting signed up is easy—just answer a quick questionnaire and a portfolio manager will pick the perfect portfolio for you.
Pros and cons of active investing
Active investing can get a bad rap, but it can also still play an important role in the investment strategies of many people.
- Attempts to outperform the stock market’s average returns. When your investments are actively managed, you or your portfolio manager can trade strategically to try and beat the market. This approach could earn you big returns that are basically unheard of in the world of passive investing. But typically, big returns also come with taking big risks.
- Investment flexibility. Unlike passive investments, which may track an entire index, your actively managed portfolio can include any number and variety of financial products that might appeal to you. This way, you have more flexibility in terms of the types of investments you make, and your fund manager can look for new and exciting opportunities that might appeal to you.
- Higher fees. In Canada, the average fee for an actively managed fund is five times greater than that of a passive fund, clocking in at 1.59%. Over time, this can seriously damage your returns.
Let’s look at an example. Say you begin with an initial investment of $50,000 in mutual funds, and you contribute $10,000 annually for the next 30 years. Then, let’s say you’ve got a return of 7% and a fund expense ratio of 1.59%.
It’s just 1.59%. How bad can it be?
At the end of that 30 years, your investments would be worth $1,391,343.17 gross according to this source.
The fees? $396,747.84!
This makes your net gain, less the fees, only $994,595.33.
- Long term underperformance. According to one study, “over the last five-, 10- and 15-year periods, 84%, 97% and 92%, respectively, of actively managed large-cap funds underperformed their benchmarks.”
- Greater risk. Because your portfolio manager is actively trying to beat the market, they are also assuming more risk than passive investors.
These risks can be substantial, but this is in keeping with what we know of active investing as a whole: more risks, possible big rewards. In a short period of time, you could win big. But over a long period of time, it is statistically unlikely those big wins would be the norm.
If you want to get more involved with your wealth building journey but don’t want to hire a portfolio manager, you may want to consider taking the self-directed route. By using an app or a website, you can plot and make your own trades.
If this sounds right for you and you’ve done your own research, check out the MogoTrade waitlist. You get instant access to free live-streaming stock prices, can build a watchlist to track your favourite stocks, and can be among the first to trade commission-free when MogoTrade launches later this year. Visit the App or Play store to download MogoTrade today.
Which investment strategy is right for me?
Only you can decide on the right investment strategy for you. It depends on your goals, how comfortable you are with risk, and your time horizon.
There may even be room for both of these types of investments in your financial strategy. You can determine this by doing your own research and speaking with an accredited expert about your goals.
Theoretically speaking, these two strategies could balance each other well. Your passive investments could build up your retirement slowly over time; your actively managed investments could help you stay in sync with your wealth building journey and even earn you a couple extra bucks here and there.
After you’ve talked to a professional and decided on your path, you could consider Moka for your passive investments and MogoTrade for your active trading.