In many realms of life, including health, career and romance, ‘active’ is usually a better strategy than ‘passive.’ But that’s not always the case when it comes to investing. ‘Active’ investing, constantly buying and selling securities in hopes of profiting from short-term changes in the stock market, can work when the market is doing well. ‘Passive’ investing focuses on a ‘buy-and-hold’ strategy, in an attempt to reap rewards from long-term trends in the stock market. Both approaches have advantages and disadvantages, according to area financial experts.
“The buy-and-hold strategy is generally a sound method of investing, with one extreme caveat,” says William Carey, president and chief investment officer at Cortland Associates. “Buy-and-hold requires a great deal of thought before you buy, and constant monitoring and review after you buy. Remember, it’s called buy-and-hold, not buy-and-forget-about.”
Most people spend more time researching a new stereo than they do stocks, Carey points out. “That’s a mistake: You should buy a stock as carefully as if you would buy a business or a house,” he advises. Passive investing requires patience and a diversified portfolio, he adds. “The only way it can work is if you make a few decisions and make them well, as opposed to shifting your portfolio in response to every little blip in the market.”
The advantages of passive investing include tax benefits. “If you’re trading all the time, as is the case with active management, you’re paying capital gains taxes whenever you sell a stock that has appreciated,” Carey explains. But when you hold on to a stock, your gains can appreciate and continue growing, he says.
The passive approach usually results in fewer bad management decisions. “The problem with active management is that it’s hard to make sound decisions when you’re trading quickly and consecutively,” Carey says. “A passively managed portfolio is designed to track all the securities traded on a particular index, so there’s less chance your investment will be affected by impulsive management decisions.”
The biggest disadvantage of passive investing is a lack of opportunity to outperform the market. “Most investors want to do better than average,” says David Ott, partner, Acropolis Investment Management. “Active managers claim they can deliver.” But passive investing often offsets market gains with lower costs and higher profits. “Two or three decades of studies have shown that it’s hard for active managers to consistently out-perform the index after fees, adjusting for risk,” Ott says. “Loss is hard for active managers to overcome. So maybe active beats the index, but not when you figure in losses, management fees and trading commissions.”
Proponents of active management claim it’s the only way to go, and vice versa. “Actually, a combination of both approaches can be most effective,” Ott says. “This is known as a ‘core and satellite strategy,’ and it is used by endowments, pensions and other institutional investors.”