Why Is Passive Investing Better Than Active Investing?
How did you spend your time at the start of the COVID-19 pandemic?
For a couple of months, millions of Americans were confined to their homes as part of the nationwide lockdown in response to the coronavirus public health crisis. With our normal social and recreational outlets no longer available, many people had more free time on their hands.
A blessing or a curse? It depends on what you did with this unexpected leisure time.
Perhaps you were glued to your television set watching CNBC or Bloomberg all day long to find the latest information, data, and signals in the financial markets. Maybe you were buying carnival stocks, shares in Clorox and Amazon, and mining exchange-traded funds (ETFs) during trading hours. But now that life is slowly returning to some semblance of normalcy, you may not have the same amount of time to actively invest and monitor your holdings in Freeport McMoRan and Alphabet.
This is where you then choose which route to take: let someone else be an active investor on your behalf or swap this strategy for passive investing? Each tactic has its advantages, but passive investing maintains many benefits that can be hard to top.
Passive or active – here are four reasons why passive investing is superior to active investing:
1. You Pay Lower Fees
Because passive investing consists of tracking benchmark indexes, such as the S&P 500 or the Russell 2000 Index, nobody picks stocks on a day-to-day basis. As a result, without this aggressive oversight, investors will pay less for these passive funds.
Not only do your returns match the long-term upward performance of the benchmarks, but you also save money on your investments. Saving money, and time? Yes please.
2. Passive Investing is Better for Your Taxes
Passive investing mostly consists of a buy-and-hold strategy. When you buy an exchange-traded fund (ETF) that tracks the Nasdaq Composite Index, you typically do not intend to sell after a few trading sessions.
Therefore, a passive investing strategy will only trigger a capital gains tax when you sell the investment vehicle. It’s for this reason that passive investing is often regarded as a tax-efficient strategy. Active investing in contrast, is different because you are slapped with a capital gains tax since it is viewed as ordinary income.
3. Diversify Your Portfolio
Active investing proponents might scoff at the notion of passive investing because they think you are not diversifying your portfolio. But quite the opposite is true because index investing gives you access to a diverse array of equities. Let’s say this is the makeup of your investment portfolio:
- 40% index fund
- 10% AMC Entertainment
- 10% Exxon Mobil
- 10% Walmart
- 20% U.S. Treasurys
- 10% cash
That seems pretty diverse, especially considering that the index fund of, for example, the Dow Jones Industrial Average, gives you access to a whole host of different companies.
4. Returns Are Better Over the Long-Term
Will you get small returns over time? Perhaps. Will your long-term returns outpace active investing efforts? The data backs that notion up.
For example, in March 2019, S&P Dow Jones Indices released its annual report, highlighting that active funds have trailed the S&P 500 for the ninth consecutive year. Once again, this shows the power of indexing.
"The figures highlight that heightened market volatility does not necessarily result in better relative performance for active investing," the report stated.
"Over long-term horizons, 80 percent or more of active managers across all categories underperformed their respective benchmarks."
What About the Best of Both Worlds?
Can active and passive investing ever co-exist? Yes; Morgan Stanley recently published a report discussing how a new "best of both worlds" approach is becoming popular. The financial institution wrote that it could make sense for investors to be passive in specific market areas while being more active in asset classes, such as international stocks and small-cap companies.
If you are starting as an investor, you would be better off being passive in your stock market journey. A great place to start is opening an all-in-one checking and investing account, which allows you the freedom to grow your money passively and work towards your long-term financial goals. The great thing about this account is that it provides personalized investment recommendations, saving you the time and effort needed to choose what to invest in. What this means is that you can start earning investment returns on your entire balance, while still retaining access to your money. A great option for those that are new to investing or don't have the time to actively invest.