How to Decide Between Active and Passive Investing

Active vs. Passive Investing: Can Both Coexist?

Many long-term investors find themselves asking this question: Should I try to beat the market, or remain content with earning close to the market average? But it’s possible that might be the wrong question. Perhaps it’s better to ask if you can be both an active and passive investor at the same time. For many investors, the answer could be yes.

“The issue is how you define ‘passive’ investing and how do you define ‘active’ investing,” said Joe Correnti, senior vice president of brokerage product at Scottrade. “It’s not as clear-cut as you might think.”

Passive vs. Active Battleground

In general, passive investing typically means trying to match the performance of market indexes, such as the S&P 500. In addition, passive investors typically trade infrequently. Active investors – on the other hand – might only hold a few stocks, or favor a money manager who targets particular sectors or companies expected to outperform market averages.

Passive investing gave rise to the exchange-trade fund (ETF) industry. And while not every ETF is passively managed, most are. On the flip side, most mutual funds are run as active funds, designed to beat market averages.

It’s these two products – ETFs and mutual funds – that have largely defined the active vs. passive battleground for individual long-term investors.

Active Buyer Beware

Active investing usually has higher costs and fees than passive investing for a couple of reasons. First, active fund managers generally are buying and selling securities (which builds up trading costs) more often than passive investors. Second, actively-managed funds tend to have larger research and management teams than passive funds, which rely on the simplicity of an index to determine their holdings.

As a result, active investors have to offset the drag of higher expenses to beat the market indexes.

Passive Buyer Beware

Passive investing has evolved considerably in recent years. Until about 15 years ago, most ETFs tracked relatively broad, well-known asset categories, like small-cap U.S. stocks, investment grade corporate bonds or emerging market stocks.

But today, relatively exotic indexes have cropped up that cater to narrow or arcane market segments. Some indexes also change their holdings so frequently, based on preset metrics, that they have more characteristics of active than passive investing.

Where Passive and Active Meet

The core of a long-term investment plan typically would call for financial assets to be allocated on a percentage basis to specific asset classes. For example (and this is strictly an example, not a recommendation), you might allocate 40% to large-cap U.S. stocks, 5% to small-cap stocks, 15% to international stocks, 15% to U.S. Treasury bonds, 15% to corporate bonds and 10% to cash.

The allocation that’s right for you depends on your risk tolerance and your financial goals, both of which might change over time. That’s a critical point in the active vs. passive debate. Many long-term investors aren’t purely passive. You might have a passive, static approach to investing that calls for matching the market averages wrapped inside of a dynamic, active asset allocation plan.

“In the end, active and passive approaches can and do coexist,” Correnti said. “But I think the bigger point is to not get hung up on terms like active or passive. Focus instead on creating and sticking to an investment plan.” 

Read Next: Active vs. Passive ETFs: What to Look For

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The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.

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