Investing 101: Active vs Passive Investing

If you read our article explaining what investing is, you should understand by now why many people may be motivated to do so. In this post, I'd like to discuss the two main investment approaches - active and passive. While both are popular, neither one is right or wrong, and both can bring high levels of return.

Passive Investing: If you’re a passive investor, you invest with long-term targets. You don't react to share price fluctuations in the same way that active investors do. With limited trading (buying and selling) of shares, passive investing is a cost-effective, sit-back-and-relax strategy. Rather than reacting to any change in a company's share price by trading a stock, with passive investing, if you buy a stock, you hold onto it, through the good and bad times, until you're eventually ready to sell (and hopefully make some profit).

An example of a way to invest using a passive approach is through buying an index fund that follows one of the major indices (stock markets), such as the FTSE 100. A FTSE 100 index tracker will allow you to effectively hold a position in each of the 100 constituent companies of the FTSE, such as Tesco or BP, all in one basket. This means that, if the FTSE 100 rises or falls, so too will your index fund. Every quarter, when the worst-performing stocks in the FTSE 100 are replaced by the best-performing ones in the FTSE 250, this change will also be mimicked in your fund's composition.

To summarise, rather than buying and selling different stocks each day to maximise returns, passive investing means doing this on a much less frequent basis, with long-term goals in place. Passive investors may check their portfolio's performance once or twice a year, and will not succumb to the temptation to chop and change their basket of owned assets as often as active investors.

Active Investing: Active investors are a lot more hands-on with their investments. While a passive investor may check their portfolio every three-to-six months, the most active investors will be doing this three-to-six times an hour! In many cases, this is an exaggeration, but if you are a full-time trader or active investment manager, it is literally your job to keep an eye on your portfolio and see if there are any potential opportunities to buy/sell stocks and shares to increase your pot of money.

Active investors constantly look across the financial markets for opportunities to buy assets at a low price, and sell them on at a higher price, making capital gains. Rather than sitting back and letting the stock markets do their work, active investors strive to beat the wider market's average returns, taking advantage of short-term price changes. Active investing requires a lot more research and analysis into companies, so that you can buy or sell at the right time. However, it can be costly, as each trade triggers a transaction fee.

In conclusion, active and passive investing are two different investment strategies. While most investors prefer passive investing, because, in the long-run, this style has been proven to outperform active investing, this is not to say that the latter should be disregarded. Active investing just requires a lot more technical and fundamental knowledge, the time to constantly check and update your portfolio, and the acceptance that you can't always be right.

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