Active vs Passive investing refers to two different investment strategies used by investors. Active investing involves the practice of individual security selection and implements a “hands-on” approach to investing. The aim is to beat a certain benchmark or look for absolute returns. Passive investing looks to match a certain benchmark and is a “hands-off” approach, often with a long-term view involving very minimal activity.

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⚠️ This platform and this article are designed for private investors who are looking to manage their own money. I may refer to active fund managers or passive fund managers from time to time. However, this is focused on active private investors i.e. those looking to pick individual companies and passive investors i.e. those who just want to invest in index funds or ETFs. Most arguments are based on Active Fund Managers Versus Passive Fund Managers and do not incorporate private investors into the mix. We all know the statistics that most fund managers with public records do not beat passive fund managers. However, private investors do not work for funds, we work for ourselves.

What is Active Vs Passive Investing?

Understanding the Active Vs Passive investing saga is the best place to start for most investors. They tend to be heavily influenced by either one or fall into one camp. When investors start, they develop a philosophy around markets and investment styles. One of the most important questions they need to answer is whether they should pick individual securities or passively invest in an index.

By answering this question early on, investors will shape their entire investing experience, strategy, and financial goals. The main differentiating factor of each approach comes down to performance. Active investing looks to beat a benchmark and focuses on absolute performance. In contrast, passive investing looks to replicate the performance of a given benchmark and capture the overall returns the stock market can provide.

Active investing involves the process of individual stock selection. This means investors research, analyse, value, buy and sell individual securities. The active approach manages a portfolio of handpicked stocks, involving constant monitoring, rebalancing, position sizing, and research, with the sole aim to beat a benchmark. This is a more time-intensive approach to investing, and it can be a bit more expensive to execute due to the trading, taxation on selling, and other factors.

On the other hand, passive investing looks to capture the overall returns of a given benchmark on the assumption that trying to beat it long-term is pointless. Many passive investors believe in the efficient markets, which is why they don’t believe inefficiencies can be exploited. The idea is that the stock market grows over the long-term, and they want to participate in this growth with minimal involvement. This is a more convenient and cost-effective approach to investing. It does not require a significant amount of time to implement post setting up and executing the strategy.

Why is there a debate around Active vs Passive Investing?

The world of investing is filled with many debates such as Value vs. Growth, Inefficient Markets or Efficient Markets, and Diversified or Concentrated. However, the Active Vs Passive “tug-of-war” is probably the biggest. Both sides have die-hard fans and valid arguments backed by a tremendous amount of research, data and “hindsight” statistics.

The Passive Investing camp argues that passive investing is the better choice. They reinforce their ideas with the most common phrase “Most active investors don’t beat the market long-term” which makes their opponents, active investors, look overconfident, arrogant, and delusional to think they have an edge. Passive investors believe that active investors are better off indexing, as it will surely beat them over the long term.

On the other hand, the Active investor camp wants more than average returns. They believe that with their investment process, research and analysis, and diligent stock selection, they can beat the market. They don’t believe that markets are truly efficient and are confident in finding inefficiencies to profit from.

Both strategies have valid reasons, and there are many examples reinforcing the central ideas behind both. If one was better in its entirety, then we would not have many super investors who have created tremendous amounts of wealth. On the other hand, incredible wealth has also been created by passively investing. Both have success stories, and both have failures.

The foundational argument for passive investing is grounded in the fact that most active investors rarely beat the markets over long time horizons. However, this argument is imbalanced and incorrect. The truth is that it comes down to each individual investor, their risk appetites, financial objectives, experience levels, and the time they want to put into it.

The best answer is to do what is best for YOUR financial goals aligned with your personality.

Why do I have a problem when they attack Active Investors?

As an investor who actively manages my investments while also taking advantage of passive investing, I have always disagreed with the foundational reasoning for passive investing. While it is indeed difficult to beat the market over the long-term, it is not impossible or restricted to elitist investors. I know many private investors who beat the market by a significant margin.

The empirical data of Active Vs Passive Investing is based on Funds, not individuals. The issue, I believe, lies within the fund industry itself rather than private investors, retail investors, family offices, and small private boutique funds.

The fund industry is a business where individuals with incredible talent may be smothered by corporate bureaucracy. A performance-driven and heavily incentivized fund industry that focuses on maximizing fees does impact the performance of active funds. They have to manage clients, capital flows in and out, match benchmarks, KPIs, risk of job loss, and humiliation for sticking their necks out. This competitive field is challenging and does skew overall returns. It is no surprise that most active fund managers do not beat the market.

Running an active fund is as much about running a business as it is about trying to outperform the market. That is where I believe the difference lies between say myself and a fund manager.

As private investors, we are 100% focused on OUR capital, with no clients or boss to answer to, or management fees. We don’t have to go along with the average to protect our careers, and every decision is independent. I believe the results would be entirely different if you took a like-for-like comparison of private investors who actively invested and those who passively invested.

*I don’t believe most public funds, hedge funds, or investment managers can outperform the market due to the reasons above.

Active investing explained.

Active investing is the process of building a portfolio of carefully selected individual stocks. The aim of active investing is to compound capital and achieve higher returns than the benchmark or the overall market. The benchmark is determined by the asset class or criteria that the active investor is focused on. For example, an investor may look to invest in small-cap stocks, and they would select an appropriate Small-Cap Index as a benchmark for comparison.

Alternatively, an investor may want to build a portfolio of high-quality companies and outperform the world index of Quality Companies. If an investor wants to beat the market by 1-2% points, they would compare to an S&P 500 index and ensure they track higher than the yearly returns.

Many private active investors, like myself, don’t use a benchmark. We are looking for absolute returns on capital. So, I may say that I’m looking to compound my capital at 20% annually, which is the benchmark. Although active investing primarily focuses on minimizing trading, there is still an aspect of portfolio turnover, which is why there is a lot more activity than a passive approach. The aim is to buy and hold the best stocks (unless you are a trader). However, along the way to finding those long-term compounders, you will need to turn over a lot of rocks and, as a result, turn over a lot of positions.

Active investors don’t believe in efficient markets and look to exploit those inefficiencies wherever they may be. It could be in undervalued companies, small-cap segments, downtrodden industries, or the boom and busts of cycles.

Active investing is grounded in an Investment Philosophy, a clearly articulated strategy backed up by a rigorous investment process, valuation process, in-depth research, and analysis, and then executed with disciplined portfolio management.

The Pros of Active Investing.

The main positive of active investing is the ability to earn higher returns. For me it is also about pursuing something I enjoy, I am relatively good at (probably questionable), and something that gives me independence. There would be no way I would be here today, independent, financially free and doing what I choose to do daily if I passively invested. No one looks at it from this angle.

To become financially free by passive investing, one would either need to have a large capital base to start with or wait decades for the dollar-cost-averaging, dividend reinvestment plans and compounding strategies to work. So while Passive investing does create long-term wealth it is much harder to accelerate wealth creation, unless you are picking thematic themes in booming markets (a story for another day).

• Chance of outperformance over a benchmark.
• Flexibility around market cycles and downturns.
• Effective Tax Management strategies.
• Can achieve higher returns – No upside limit.
• The ability to create wealth in a shorter time frame.
• An independent approach allows more focus.

The Cons of Active Investing.

There are of course risks to active investing. Whether it is from a poor investment process, lack of knowledge and understanding, or the inability to value or decipher financial jargon. The biggest threat to active investing is the investor. They will be faced with many psychological biases, behavioural pitfalls and the constant fight against greed and fear. Many lack the patience and discipline to stick to a rigorous and systematic approach to actively picking stocks.

• A significant amount of work involved.
• The chance of capital loss and exposure to downside risk.
• Ongoing and consistently requires your attention.
• Requires discipline, patience and a process.
• May increase fees from trading, including tax bills.
• More prone to error as there is more behavioural exposure.

Who is Active Investing for?

It’s important to note that Active Investing is not suitable for everyone. To be successful in generating returns over the long term, you need to have a genuine curiosity, passion, and interest in the subject. If looking through annual reports, analysing charts and financial statements, and researching companies doesn’t excite you, then it’s hard to stay motivated. I have a natural curiosity about whether a company is public or private, and I’m always interested in learning more about different brands, companies, and industries as well as the economy.

In my opinion, if you’re only spending a couple of hours per week or doing it as a hobby, then it’s not worth actively picking stocks. It’s not as simple as just buying brands you know and sticking to your areas of competence. You don’t need to be a finance expert, but you should have a basic understanding of valuation and accounting to assess a company. I have yet to meet any investor in 15 years who has beaten the market and said, “I am not interested in investing and the stock market does not excite me”.

Active investors should enjoy the work, this is what creates consistency of actively sifting hundreds of ideas annually. Most private investors would be better off with passive investing. You need a view or philosophy about markets, the economy, or industries. If you don’t know how to analyse opportunity then that significantly increases your risk exposure. The risk does truly come from not knowing what you’re doing.  

In summary, Active Investing is best suited for those who have a genuine interest in the subject and are willing to put in the time and effort to research and analyse companies, as well as refine their skills over a lifetime.

Passive investing explained.

Passive Investing is a strategy that involves investing in Index Funds or exchange-traded funds that match a certain benchmark. The main objective of this approach is to replicate the performance of the benchmark and capture the overall return of the market, instead of trying to beat it. This philosophy is based on the idea that over the long term, the market climbs higher, providing reasonable returns through the magic of compounding.

Passive investing follows a long-term holding approach while ensuring the fees remain low. The low-cost structure of passive investing makes it very attractive to investors. It is a hands-off approach that usually follows a dollar-cost-averaging and dividend reinvestment strategy. It can be used by all types of investors, from beginners to high-net-worth individuals.

This strategy works, and there is no debate about it. There is a certain level of set-and-forget involved, as there will be some rebalancing and performance checks. However, it is mainly based on sticking to the plan in the long term, through all market cycles. Most passive investment strategies remain fully vested in all market conditions, removing the need to be correct about stocks and markets.

The Pros of Passive Investing.

There are a lot of positives to passive investing. On the basis that is it a part of a long-term strategy. The returns for the minimal involvement are reasonable. The low-cost options that are in the market have allowed everyday investors to benefit from the growth of markets. To get returns without having to actively pick stocks is great for most investors. It is simple for beginners to understand and start, it is also great for investors with a lot of capital who want a return and have better things to do than scan markets and read annual reports.

• Outperform over the long term.
• Low cost fee structure making it more cost effective.
• Can be tax effective as minimal selling.
• Great long-term wealth builder.
• Gives investors more time to do what they want.
• Lowers risk to Systematic risk.
• Fund transparency.

The Cons of Passive Investing.

The downside of passive investing will come down to returns and the long-term aspect. You truly need a long-term patient view to see the power of compounding work. You are also limited to the average returns. There is no upside potential for outperformance. When a bear market happens, you have minimal defensive positions as exiting defeats the strategy. There will be a psychological element involved in watching capital evaporate and not acting against it. You will also have a lot of trust in the long-term market continuing in the same trajectory as it always has.

“Past performance is not an indicator of future performance”. Just because an index has historically returned 9% annually this does not mean it will for the decades the come. You are riding on the basis that in 10-20-30 years, your returns should be in line with this historical average.

• Often no exit during bear markets leading to loss.
• Does not eliminate market or economic risk.
• Limited to average returns, no more or less.
• Limited opportunities and flexibility.
• Requires a long-term view and a lot of patience.

Who is Passive Investing for?

Passive investing is suitable for a variety of investors. This includes those who want to capture returns in the stock market, investors looking to invest for their retirement, inexperienced investors, experienced investors, beginners, and sophisticated investors. Passive funds are designed for everyone and play an important role in diverse portfolios.

For investors who don’t want to actively sift through companies, read annual reports, or engage in active stock selection, passive investing offers the opportunity to participate in the wealth creation that the markets have brought. Often, the question isn’t whether investors should actively pick stocks or passively invest in index funds, but whether they should invest in the equities markets at all. Passive investing provides a great entry point for those new to the stock market or investing.

Passive investing is suitable for investors who want exposure to the markets as part of a diversification strategy. It eliminates the need to pick individual companies, conduct extensive research and analysis, and spend a lot of time actively selecting stocks. For investors who still believe in the idea of investing and want to prudently allocate their money to work for them, but have other things to do with their time, passive investing may be the better option.

However, it’s important to note that passive investing does not eliminate the need for portfolio management.

Which one is a better strategy?

The question of which investment strategy is better is a common one. However, there is no one-size-fits-all answer. It is possible to find data and evidence to support both active and passive investing. Confirmation bias is often present in these debates, with each side having its own die-hard supporters. Rather than defending one’s position, it is better to acknowledge that both approaches have their pros and cons.

Choosing between active and passive investing depends on personal circumstances. If you believe that markets are efficient and that it is difficult to beat them in the long term, then passive investing may be the way to go. On the other hand, if you have the skills, discipline, and patience to identify market inefficiencies, then active investing may be a better option.

One of the most important factors to consider is your curiosity, interest, and passion as an investor. If you are willing to put in the effort, develop your skills, and accept both successes and failures, then you may lean towards active investing.

It is important to note that there is no “better” or “worse” approach, they are just different. Both active and passive investing can be effective ways to create wealth. They are simply different approaches to achieving the same goal.

There are no definitive answers to this question. What are your investment goals? How much time can you commit to investing? Know thyself, meaning, are you aware of the psychological, behavioural, and emotional challenges of investing? Would you rather have a cocktail and sit poolside than read financial reports? Are you experienced or not?

One thing I will add if you think that outperformance is easy by actively picking stocks, then you are most definitely going to get wrecked 💥 .

Why not a blend?

If you recall the Psychology component of this blog, you might remember the section called “Know Your Behaviour,” where we talked about false dichotomies or choices.

False choices are when our minds present us with an either/or option instead of considering both options (and all the options in between). I believe that there is a place for a combination of both passive and active investing in everyone’s portfolio. Instead of saying one option is better than the other, we should think about how they can work together to help us achieve our goals.

Investors can benefit from a combination of both strategies through a core and satellite portfolio. Most strategic asset allocation and tactical asset allocation strategies will incorporate a blend of these two to help achieve long-term financial goals.

I find this approach to be the most practical. For example, an investor may choose to focus on the small-cap sector of the market and actively pick winning companies. To offset this focus, they may choose to invest in an index fund that captures all the companies at the top end of the market. Using a combination of index funds with actively selecting companies can produce fantastic results. It not only minimizes risk, but also helps to diversify your portfolio and hedge against the challenges of stock picking.

Of course, some investors may have strong preferences for one strategy over the other and may think a blend is a poor strategy overall. However, we all have different needs, risk profiles, time horizons, goals, experiences, and time allocated to investing. Therefore, there is no catch-all approach.

In Summary…

Investors often debate about whether active or passive investing is better. This blog doesn’t provide a definitive answer as it is highly subjective, but it explains the strategy behind each one. Both strategies have their advantages, and investors need to do their own research to determine which one is more suitable for them.

Passive investing has become more popular over the last few decades, with many investors flocking to indexing. However, even the passive investing universe has thousands of passive funds and index funds with different fee structures to choose from. Making that a challenge in itself.

Investing is not easy, and the feedback loop in investing means it could take years to see if your strategy pays off. If you are interested in active investing, then read through each of the 5 P’s methodically and expand on your knowledge in each section.

Regardless of which strategy investors choose, it is essential to start small, learn as much as possible, and not get overconfident. Investors need to remain vigilant at all times to make the most informed investment decisions. Never deploy capital into the markets without knowing what you are doing and without a plan.