Active and Passive Investment Management

How do you manage your money?

Asset management methods tend to fall under two main philosophies: active and passive. But how do you know which investment approach is right for you? Understanding the opposite ends of the spectrum can be a great starting point in learning which style best suits your investments and can help you reach your financial goals.

Active vs. passive

When it comes to long-term investing — the type of investing for your nest egg — a debate that seems to be ages old has grown in intensity fairly recently. This debate centers around the ideas of active and passive investment management styles.

I wanted to spend some time describing what active and passive investment management styles are and cover a few of the purported advantages and disadvantages of each. This isn’t a plug for either style in particular. Rather, it’s an attempt to help you gain some traction when you hear others discuss this topic or read about it in the future.

Active

Let’s start with active management. Active investors and investment managers believe, effectively, in chaos. More specifically, they believe they can exploit chaos for investment gains. It’s a belief that — with all of the information available about a stock, a bond, or even an entire market — someone or everyone is missing something. And those critical details give the active investor or manager an advantage.

An active investor’s or manager’s usual objective is to “beat the market.” Harnessing the advantage of seeing something that others have missed to outperform the average investor in a particular segment of the financial markets, or an index like the S&P 500.

Truth be told, the idea that beating a market or index is even possible is one of the largest advantages of an active investment management style. Between the two, active and passive, active investors and managers are the only ones who can realistically do it. However, this folds directly into one big disadvantage of active management: being wrong and, consequently, not outperforming a given market or index … but actually underperforming it.

Also, because active management inherently involves a greater velocity of money — moving money from point A to point B, buying and selling various stocks and bonds — the expenses associated with active management styles tend to be higher than more passive styles. And at the same time, active investment management can also create more potential tax liabilities because of that very same velocity of money.

Passive

Passive investors and investment managers, on the other hand, believe in order. The passive investor believes that — with all the information available concerning a stock, bond, or market — there is nothing to take advantage of. All the relevant information is already known and already priced in.

A passive investor or manager’s objective is not to beat the market but, rather, to “be the market” — to match performance to that of a particular financial market or index. The whole idea is to follow along for the ride, more or less.

Since outperforming a market or an index isn’t a goal, the focus turns to minimizing what is called “tracking error,” or the extent to which a passive investor or manager doesn’t follow a given market or index in lockstep. If the investor can minimize or eliminate tracking error, the tradeoff for not being able to outperform a market or an index is knowing that it can’t be underperformed either.

Passive management employs more of a “set-it-and-forget-it” type of strategy, for the most part. Therefore — sans tracking error minimization — expenses related to implementing a passive strategy are typically lower than active. The same also holds true for taxable transactions. Again, the velocity of money is considerably slower with a passive strategy.

What you chose for your nest egg depends a lot on your belief in either style. Does the possibility of outperforming markets appeal to you, or are you a believer in the old mantra “slow and steady wins the race?”

The good news is that blending the two is also a valid option … but, in any scenario, you should consult with your own financial advisor on what’s best for you.