Active vs Passive Investing Explained

When considering active vs passive investments, the biggest influencing factors are your investment objectives, your personal circumstances and your personality. These all combine to send you down a certain path, but first of all we need to understand the fundamentals of what active and passive investments are.

By Jon Howe6/12/20

Like many things in the complex sphere of investments, recommending the merits of active vs passive investing can depend on who you are talking to. People have different agendas, and while a novice investor might be interested in simple small investments to make money, an expert investor or a financial advisor might be looking at things from a completely different angle. Furthermore, over time, you can evolve from being a passive investor to an active one, and vice versa.

What is the difference between active and passive investments?

Active investments are where you take a hands-on approach to manage the investments yourself. This means you make the decisions, carry out the communications, study the markets for imminent fluctuations, research the investments for potential returns and generally manage your portfolio yourself.

Whilst this results in you playing an active role in managing the investments, it also means you are active in terms of responsibility, so you have to stand and fall by your decisions. Active investing can be about pot luck, but you might prefer to call it timing, or being prepared. Either way, active investing takes time and knowledge and is very much the skilful management of short term investing for higher returns.

Meanwhile, passive investing is about longer term aims and growing money over a period of time. A passive investor is not too concerned by short term fluctuations in the market, and they have no desire to obsessively study figures and get churned up by minor market changes, they prefer to pay other people to worry about that.

Passive investment requires initial research and advice, of course, but it means you are tasked with making a decision and sticking to it. Passive investing essentially involves less volatile schemes, or known quantities with more predictable trends, and where profit is more likely but also more steady, so in essence, you can sit back and watch it grow.

Active investing

The clearest example of active investing is in stocks and shares. Here, an active investor will buy and sell stocks using a broker or a fund manager, and the objective is to invest in companies that will outperform a specific index. You are trying to beat the market, so you have to pay close attention to market trends, shifts in the economy and the political landscape, plus other factors that can affect the business climate. The ‘active’ characteristic also applies in terms of having to make quick decisions based sometimes on detailed analysis and sometimes on pure speculation.

Indexing does eliminate some of the risk of active investing in stocks and shares, as it reduces the element of human error in terms of making stock selections, as the index tracking does this for you.

Who is best suited to active investment?

An active investor needs to have the courage of their convictions and be both dynamic and thorough, but also confident and bold. You will be someone who likes to take control of their ambitions because active investing is effectively a full-time job, it can’t be done half-heartedly.

Becoming an active investor means you will be existing in a new environment and will be able to thrive in it, you will normally live for this kind of thrill. But it also means that you need to be able to cope with short term setbacks – both financially and mentally – and this usually means that active investment is better suited to people with fewer commitments, in terms of work, family or property or other financial restrictions.

What are the benefits of active investments?

  • Your choice – You can take a flyer if you believe in a certain investment and you have the flexibility of not following a specific index.
  • Build-up a portfolio to suit you – Effectively you can hedge your bets by using different investment techniques, which helps to even out the wins and losses. So you are not locked into long term investments and can buy and sell according to both information and instinct. If an investment is not performing well you can sell it, and if it is performing well, you can buy more. With a passive investment you are stuck with it, however it is performing.
  • Tax benefits – Whilst an active investor is prone to capital gains tax, you can manage your portfolio to offset tax hits, ie. you can sell investments that are losing money to balance the tax demands on stocks that are earning you money.

Passive investments

There are many examples of passive investments, but to show how active vs passive investment returns CAN be similar, this is best illustrated through looking at ETFs. This is an exchange traded fund and can be set-up by a passive investor so there is not much input needed into how it runs. An ETF protects you from different market conditions because you are putting money into many different stocks and shares, not just a single company.

Stocks can also be more ‘passive’ by investing in an index fund. Here, you design a portfolio to track a market index and generate returns in line with a chosen index, not to outperform it. This means there is less management involved and hence, there will be less costs involved.

Other more traditional forms of passive investment are pension funds such as SSIPs and SSAS, which are long term, flexible investments with tax benefits attached. Savings accounts such as ISAs are also a passive way to invest regular or irregular amounts which can build up each year, and also enjoy tax benefits.

Property crowdfunding is considered to be a passive investment vehicle also, as it spreads risk and liability and you essentially invest in a share of a property and leave it to the crowdfunding vehicle to manage, whilst you wait for the returns. In addition to property, crowdfunding can involve investment bonds, innovative finance ISAs and P2P/peer-to-peer lending, all of which can potentially bring higher returns than traditional saving, and with peer-to-peer lending you can enjoy some tax benefits also.

Who is best suited to passive investment?

A passive investor tends to be someone who can take a more circumspect or detached view of investing, and doesn’t need to be involved in the cut and thrust of it. This may be an older person or someone with more family or financial commitments. They may be taking a longer term approach because they are just saving money for their retirement, or they have young children and want to save money for them to go to university or start a business in later life.

A passive investor might like the idea of being savvy with money, but is not a financial analyst and has no desire to get involved in the nuts and bolts of investing. They are happy to leave that to the experts.

In terms of character traits, perhaps a passive investor is less of a control freak, and they prefer to hold some trust in other people. They are also not restless or too ambitious, they are not looking to make a career or a full-time job out of investing, they just want to see a steady return on their investment and to use their money smartly.

What are the benefits of passive investments?

  • Cheaper investments – Even with stocks and shares, passive investment is usually cheaper, because you are following an index, not picking new stocks to beat others, so there is less management involved and hence less fees.
  • Tax benefits – The buy and hold strategy of passive investing avoids big capital gains tax hits.
  • Less risk – Steady, passive investments avoid volatile markets and therefore there is no requirement to make decisions which could backfire whilst you chase higher returns. Passive investment also means you are not at the mercy of potentially bad advice or influence.
  • Longer term benefits – The general rule is that investments left over the longer term are more likely to produce financial returns, because you can ride out the peaks and troughs that most markets experience, and not make potentially knee-jerk or reactive decisions. With passive investment, patience is the key.

How property investment can affect active vs passive investing returns

The property market is a relatively stable method of investment and is built on historical trends which are easier to predict than many other investment markets. It also offers points of access which are attractive to both active and passive investors, and in that sense is quite unique. There are opportunities to take a hands-on approach and make decent returns very quickly, and there are ways you can invest for the long term and take a back seat approach.

Easily the most active method of property investment is to get into property development. Here you can study the market intensively to pick up a bargain in a good location, work on it – either yourself or managing a team of skilled contractors – to make it marketable and then flip it for a justifiable profit. Many property developers can quickly build-up a business this way, but it is rife with potential pitfalls and can be a complex business of managing people, markets, bridging finance and estate agents. Naturally, this can become a full-time job, and while it can bring higher and quicker profits, it can also bring headaches.

Many property investors also go into the buy-to-let market, and again, this can be suitable to both active and passive investors. As an active investor you can buy, develop and manage the investment property yourself, which means finding tenants, sorting contracts, chasing rent, fixing repairs and carrying out maintenance. It means you are liable for all costs, but also that you receive all rental income. A passive investor may do the same, but pay a letting agent to look after the property for them. This entitles them to all the income and none of the hassle, in return for a regular fee to the agent. 

In both cases you can build up a portfolio of rental properties, which is a different way of diversifying your investment, and relying on different sectors of the market. But as with other active and passive investment opportunities, it really depends on your investment objectives, your personal circumstances and your personality.

Does crowdfunding appeal to both active and passive investors?

Crowdfunding does offer an investor the best of both worlds, in that you can invest modest amounts or bigger amounts, and you can diversify your portfolio as much as you want. Crowdfunding does, however, perhaps appeal to passive investors more.

You can be active in terms of choosing properties or other vehicles to invest in, and you can decide yourself when you wish to withdraw your money from an investment. However, the safety factor of crowdfunding, namely the fact that the investment vehicle is professionally managed by an accredited business, favours the nature of passive investors.

Property crowdfunding appeals to passive investors because you can leave your money in and earn rental income and capital appreciation over the long term. There is a low entry point for this style of investment, which appeals to novice investors, whilst still enabling them to build up a portfolio and diversify their properties over time. And in that sense, property crowdfunding is perhaps the closest investment method available that will suit both active and passive investors.

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