The promise of the stock market is wealth creation; however, how to pick the right stocks feels to most like navigating a stormy sea. With over 43,000 listed companies, it can be pretty hard to pick out what to buy. Understanding the two approaches to picking stocks—active and passive investing—empowers individuals like you to make an informed decision on how to chart a clear course toward financial goals.
The book delves deep into active and passive investing, covering all basic beliefs of these strategies, the arguments against and for them, to finally end with one able to choose an investment approach that best blends with personal risk tolerance, investment horizon, and financial goals. And it turns that befuddled sailor into a confident captain, navigating the stock market with clarity and purpose.
Active Vs Passive Investing Strategy
Even the New York Stock Exchange sees many tickers in activity running into billions every day. With over 43,000 companies vying for the eyeballs of some investor or another worldwide, it is little surprise that investors find this sea of stocks very hairy to navigate.
But for those with a view to amassing wealth, knowing what stocks do investors invest in is but the first step on a strategic investment journey.
Picking Stocks and Investor Objectives
ssentially, a stock represents fractional ownership in a company. This concept implies that when you buy a stock, you are essentially buying a small piece of that respective company. The value fluctuates up or down based on the firm’s profitability. The price ultimately represents the consensus of all investors about what the company—and the stock—is worth. Indeed, the price of a stock may swing wildly on speculation about future prospects, even for companies that don’t have earnings yet.
Different investors participate in the equity market with various objectives in the return generation process. Some simply strive only to outperform inflation, while others want to “beat the market,” which in turn means higher rates of return compared to the average performance of the overall market. It is this second concept of “beating the market” that forms the underpinnings for two different schools of investing thought: active and passive investors
Active vs. Passive Investing: Revealing the Strategies
The thought of “beating the market” propels an active investment approach. Active investors assume that through astute stock selection and perfectly timed trades, there is value in outperforming the market. The benefits from the short-term inefficiencies in the market, where a few stocks are relatively over- or undervalued compared to their intrinsic worth, are gleaned by the active investor. The active investor will use a variety of methods to find undervalued jewels. They will dissect a company’s financial statements, study historical price trends, and may even use algorithms to discover hidden patterns.
Contrasted to this view are passive investors. They take the long-term perspective that inefficiencies in markets will get ironed out over time. Their approach will be to buy a broad basket of stocks, replicative of the market—this basically means they are not trying to beat the market or doing any kind of market timing.
This is most commonly done via index funds, which are essentially portfolios of stocks that mimic some segment of the market. One of the most common benchmarks is an S&P 500 index that replicates the performance of 500 large US companies. Stocks held by passive investors are generally held for a long period of time, overlooking short-term market volatility in favor of long, more stable growth.
Pros and Considerations Active vs. Passive Investing Strategies
Compared with passive investing, active investing can generate better yields, especially for skilled investors who take advantage of inefficiencies in the markets. In terms of active investing, a good deal of time, effort, and expertise is needed for researching and analyzing individual stocks. Inherent risk is higher because of the challenge of picking the right stocks all the time.
Passive investing is simpler and more hands-off. One essentially gets access to a diversified portfolio by buying the index fund, which mirrors the market performance. Through this, each individual is invested in a wide array of companies. This minimizes those risks associated with picking stocks and entails less ongoing management. Because of this, however, passive investors usually accept average returns that are aligned with the market and forgo the prospect of exceptional gains attainable with active investing.
Finding the Right Fit
Each investor is different, and therefore, based on an individual’s goals and risk tolerance, his or her investment philosophy, the strategy that works best for each one of them would be different. Some may find an approach that includes some middle ground between both working best. For example, a portion of your portfolio can be actively managed by picking individual stocks, while another core part consists of index funds invested for long-term growth and diversification.
Beyond Active vs. Passive: Other Factors to Consider
Investment Horizon: Are you saving for a near-term goal, like a down payment on a house, or are you investing for retirement that could be decades away? Short-term goals will likely require a more conservative approach, while long-term goals can withstand a higher risk tolerance.
- Risk Tolerance: How much are you comfortable losing? Active investing has an above-normal risk premium associated with it, whereas passive investing is way more equilibrated in both directions.
- Investment Fees: Most actively managed funds generally charge higher than passively managed index funds. Lower fees can make a big difference in your long-term returns.
