Would you rather spend hours diligently performing fundamental analysis, or just buy a benchmark instead?
While many successful investors do drain sweat and blood while investing actively, the masses just pick up an index fund or an ETF and just stay satisfied. If you spend most of your time on a day job or business, then it would be a wiser option to invest passively as it requires little to no research. However, if you have enough knowledge about investing and know how to play the game, then active investing would be a welcoming choice. Although there have been countless debates as to which investing strategy is best, none have actually reached a proper conclusion.
This is mainly due to the fact that each individual has different skill sets, time and dedication for investing. With that being said, both passive and active investing have their own pros and cons. The real question is, which type of investing suits you best?
Passive investing revolves around the practice of buying and holding financial securities. These investors believe that a stock has true value, which it will eventually trade for. They calculate this value (also known as intrinsic value) and will buy the stock if it trades below the intrinsic value. This is also known as value investing and it restricts excessive amounts of buying and selling. By investing in an index or mutual fund, you reduce risk and enjoy the overall growth of the market. Now you must be wondering how index funds reduce risk. If one company performs poorly this year, there may be some other company doing well. But instead of just a handful of companies, passive investors put their money into funds and ETFs that constitute hundreds of companies. In this way, the profit will swallow the loss.
However, even though you are limiting risk and avoiding research by investing in benchmarks, remember that you have no chance of performing better than the average market growth. Investing in funds such as the S&P 500 will provide for only 8 percent annual returns, which can easily be surpassed by many individual stocks. Along with all of this, there is another factor that investors look out for. Fees are charged for management and operating costs, and they are usually expressed as a percentage. But you don’t have to worry about fees, as much as active investors have to. Investing passively requires little to no fees at all!
According to CNBC,
“Passive investing generally costs around 0.20 percent a year in fees, compared to around 1.35 percent for active investing.” Believe it or not, that is a major difference, especially if you’re willing to invest a huge amount of money.”
If you’re someone who loves to sit on a rocket and fly straight to the moon, then active investing is for you! By doing the necessary analysis, you can pick out a stock that will skyrocket in the future. Your stocks would have the potential to provide higher returns compared to the benchmarks. It would put you in a better financial situation and would make your money work harder for you. But do you really think it’s all fairies and rainbows over on this side? No, of course not! Regardless of the amount of research or analysis you do, there is always some degree of risk involved.
Yes, your hand-picked stocks can outperform the benchmarks, but they can also underperform. Active investors are always exposed to volatility and they have to use it to their advantage.
Have a look at what Investopedia has to say about the same:
“It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond, or any asset. A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors, then gaze into their crystal balls to try to determine where and when that price will change.”
The fees charged for active investing are significantly higher, compared to the passive side of the spectrum. You will also find yourself paying a lot of capital gains tax in the process. I’m not saying that active investing is a poor choice compared to its passive counterpart. It’s just that you’re not dependent on the overall market to make returns. The goal is to outperform the market. So, your strategy and analysis are crucial, in order to pick high-performing stocks and make higher returns. You may have seen traders on Wall-street. They go to the extent of using complex computer algorithms to predict the market. Not everyone has to be an extremist. There are also many active investors who use the buy-and-hold strategy. They don’t pay heed to short-term losses, but instead, believe that the company they have chosen has the potential to perform better in the long term.
Conclusion: If you believe in diversification and don’t believe in your investing capabilities, active and passive investing act as an amazing duo. I suggest keeping 60-70% of your portfolio in the form of benchmarks and the other 40-30% as individual stocks. As you gain experience and gain enough confidence, you can start reducing the number of benchmarks and start buying individual stocks.
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