Successful investing is a result of picking the right stock, applying the right investment strategy and maintaining the right discipline. While there are many advisers out there that would help you in picking the right stock, picking the right strategy is something that has to be done by you as an individual investor based on your risk appetite, financial goals, and time horizon of investment.
Despite all the complex investment strategies suggested by various investment advisors, if we look at them from a broader perspective, all the strategies can be broken down only into two investment strategies. Active investing and passive investing.
Active investing is to entrust your money to a fund or portfolio manager who will try to use their expertise and insight to choose a series of stocks, shares and investment opportunities that they hope will beat the market and make you rich by delivering big returns. Funds managed using active investment strategy are called active funds.
The goal of active investing is to beat the benchmark index by a wide margin, and maximize the return on invested capital. Active investment requires much deeper analysis and expertise to understand when to get into a stock and when to get out of it. The portfolio manager, with a team of analysts, goes through qualitative and quantitative aspects of a stock to determine the right time and price to enter or exit a stock.
An investor using active investment strategy for his portfolio must have faith and confidence in his analysis. Fund managers of active funds have to be continuously vigilant about their funds performance and requires being right more often than wrong. Some examples of popular active funds are Hedge funds, Equity funds, leveraged funds.
Passive investing, on the other hand, is a much more relaxed and laid back approach to investing, where an investor invests in an index fund, which simply tries to mimic the movements of a benchmark index instead of trying to outperform it. The idea behind passive investing is to follow the market movements, taking advantage of long term growth that the index presents.Funds that follow passive investment strategy are called passive funds.
Since passive investing does not try to outperform the markets, the investors remain more relaxed and have a longer time horizon for their investments. Passive investing is much cheaper than actively managed funds where an investor has to bear the fee charged by the fund manager for his services.
On the other hand, growth in passive investment instruments is much slower compared to actively managed funds, as the portfolio remains largely the same irrespective of the market conditions. In other words, unlike actively managed funds, portfolio of passive funds is seldom optimized to maximize the performance of the fund. Some of the most popular investment instruments for passive investing are index funds and ETF (Exchange Traded Funds).
Just like two sides of a coin, both active investment strategy and passive investment strategy have their own advantages and disadvantages, both of them are mentioned below:
Advantages of Active investment strategy:
Flexibility: Actively managed funds are tied to fewer rules related to choice of asset class. Unlike index funds, that have a boundation to invest only in those stocks that are a part of an index, active funds can invest in small companies with high growth potential.
Hedging: In some cases, active funds can also use hedging as a strategy to minimize short term losses that may occur due to sudden market volatility.
Customizable: Most actively managed funds (especially portfolio management services) create a highly customized portfolio of different asset classes, tailored as per the financial goals of an investor.
Disadvantages of Active investment strategy.:
Expensive: Most of the actively managed funds charge their investors a fee known as exit load, which is charged by fund manager for his services at the an investor decides to exit the fund. The exit load varies from 1% to 2.5% of the total AUM (Asset Under management).
May not outperform: If we analyze the historical performance of actively managed funds ?a large majority of them have failed to outperform the markets. Only a handful of these active funds have been consistent out performers for along period of time.
Advantages of Passive investment strategy:
Low fees: Passive funds use benchmark index as their portfolio, so there is no need for a fund manager to actively manage the fund. This is cost saving as there is no one actively picking stocks for you.
Automated: Since passive funds follow the benchmark index, changes in the structure of the benchmark index automatically gets reflected in passive funds.
Tax efficient: Investors of an index fund use buy-and-hold strategy, and invest with a long term horizon. Since capital gains from long term investments are exempted from tax, these funds are very tax friendly for investors.
Disadvantages of Passive investment strategy:
Mediocre Returns: Since passive funds are usually tied to an index, they are not supposed to beat the markets. The holding of the fund do not change no matter how good or bad the market condition is. Because of this restriction, passively managed funds usually give mediocre return to their investors compared to actively managed ones
Not customizable: An investor has no option to customize his portfolio in order to maximize gains and minimize profits, a freedom that is provided by actively managed funds.
Which investment strategy is better?
The question now is, which of these two investment strategies is better? At first, it may seem obvious that active investing is a better choice as it is actively managed by an experienced fund or portfolio manager, who keeps a close eye on the events that may have an influence on his performance of a fund.
But if we look at the historical data of active funds, it paints a completely different picture. Contrary to popular belief, most of the active funds fail to outperform the market. Only a small fraction of actively managed funds have managed to do so for a fairly long period of time.
Does it mean passive investing is a better investment strategy than active one? Well, not always. The choice of fund depends on what you want to achieve out of your investments. Here are some very simple factors you should consider before choosing between two strategies.
Chose Active investment strategy/funds if
You are short or medium term investors, with high risk appetite and willingness to take risk in order to maximize return on invested capital. Active investors and fund managers also take short term leveraged position in the market and use hedging strategies to protect their investments from probable short term losses.
You are an investor with large capital, and is looking to generate regular income via dividend investments. Such investors, can buy a handful of high dividend yielding stocks and hold them for long term to generate a regular cash flow via dividends.
Chose Passive investment strategy/fund if
You are looking to make money via capital gains by investing in stocks through long term investments. Such investors buy an index fund and hold for long term, which over the years, generates multifold returns by using the power of compounding returns on their investments.
You are an investor with little or no time to track the market on a regular basis, and is looking for an investment option which provides decent returns over long term, allowing you to sleep peacefully at night without worrying about daily fluctuations of the market.