Passive v Active Investing – What Works Best

Posted on: 05/05/2020

Raffi Pailagian
MBA, BSc, DipFP
Financial Planner / Managing Partner

Categories: Financial Planning & Advice Investing Superannuation Advice Wealth Management

Coke or Pepsi? DC or Marvel? Apple or Android? Most people favour one over the other. Broadly speaking, you are likely to favour either Passive or Active investing. Both strategies have their pros and cons as well as being suited to a particular type of market activity, which this article Passive v Active Investing investigates.

While Passive investing aims to match the market via a specified Index, Active Investing aims to beat it. So which is better and why?

Passive Investing

Passive investing is all about investing in the share market without the need to pick individual stocks. The aim here is to take advantage of the upward trend of the market over years.

The benefits of Passive investing include:

Low Cost – because it is largely set and forget, you will have low management and transaction costs
Certainty – because Passive investing aims to track the market, and is generally tied to an Index, like the S&P/ASX200, you know what you are getting
Lower Volatility – as passive investors are not holding a more concentrated portfolio of individual companies, the volatile swings that those stocks experience will not be directly felt by the investor
Tax Efficiency – since you are making lower returns and fewer trades in each year, you are unlikely to be hit with a big CGT bill

The downside of Passive investing is:

Available Choice – Since this form of investing tracks the market, you are more or less limited to indexed ETF’s[i] and Indexed Managed Funds
Connection To Market Cycles – Returns reflect the market and only boom when the market does

A Passive investment strategy will aim to incorporate all the stocks in a given market Index, in the same proportions as the Index.

Active Investing

Active investing is all about investing in specific companies or stocks on the market, with the aim of generating a better return than the market via those stocks.

These stocks can be in sectors that are more favourable over a particular economic cycle, or specific stocks across different sectors, based on the investors objectives, such as investing in undervalued stocks.

The benefits of Active investing include:

Transparency – you know the stocks you hold and can easily track them. You are also not exposed to companies or market sectors you don’t want to invest in
Flexibility – you can sometimes pick up undervalued stock and make some great returns, since you are not locked in to mirroring an index
Tax Benefits – if you make a loss, there is an opportunity to offset any CGT you may have incurred on other investments

Of course, there are downsides:

Cost – It can be more costly as it requires an analyst or fund manager to asses the market, and transaction costs can be high if the portfolio is traded actively
Volatility – can be higher if specific stocks move up or down more than the market

If you are considering Active investing, it is essential you do your due diligence on the advisor or analyst you intend to work with. They will need to know when to pivot, when to hold, continually assessing the market through in depth qualitative and quantitative analysis, as well as individual stocks. Their experience and skill can make a significant impact on the performance of your investments, especially over the long term. Our blog What Makes a Good Wealth Manager, can give you some tips on how to go about choosing the right person for the job.

Historically, certain asset classes have proved more profitable than others with an Active approach, and again, this is something your advisor should be aware of. Since these stocks are often more risky than some others, this can make Active Investing more appealing to those with a High Risk investment profile.

Best of Both Worlds

Despite the rivalry between the two camps, it is generally acknowledged that a combination of Active and Passive investments will provide investors with the best overall plan. This strategy maximises diversity, thereby helping to manage the overall risk.

How you might structure your Passive/Active strategy depends, as always, on your situation. Unlike the set and forget nature of Passive investing, the balance of how much you have in Passive vs Active investments will likely change over time, as your life and the market change.

Which approach you take will depend heavily on your level of interest, available resources you can apply to chasing results (time/money), the condition of the market, your financial goals, your underlying risk profile and your stage in life.

The one thing every advisor would agree on though, is you should keep an eye on your investments and regularly review your strategy to make sure it remains in line with your goals.

If you would like to discuss your financial situation and get some investment advice based on your own circumstances, please give us a call on 02 9976 3388 or click below and we’ll be in touch.

[1] An EFT – Exchange Traded Fund is similar to a mutual fund, but is listed, bought and sold like ordinary stock throughout the day, rather than once a day after market close. The benefit of an EFT is it is cheaper than buying stocks individually