Active vs passive investing

Want to learn the difference between active and passive investing? Discover the pros and cons of each to help you decide which strategy might suit you best.

Which is better: active or passive investing? It’s a common debate among investors – and some feel passionately about it. The truth is that both approaches have their place and their risks, and the right one for you will depend on your goals. Our guide covers the key need-to-knows.

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It’s worth having a decent grasp of both active and passive investing strategies; for one thing, you can use a mixture of both. And you may want to switch between the 2 tactics at various stages. We’ve run through the benefits and drawbacks of each.

Active vs passive investing: What’s the difference?

The simplest way to picture the difference is to think of an active approach as “hands-on” and a passive strategy as “hands-off”.

Both ways involve some input from you but active investing involves either you or a professional adjusting your course regularly, while passive means setting your course and mostly sticking to autopilot.

At its core, active investing attempts to beat the returns of the market, whereas passive investing usually attempts to match or mirror market performance. But success is never guaranteed with either option.

A helpful metaphor to consider is driving a car and navigating yourself (active) vs using a sat nav (passive) to reach a destination (ideally, wealth!).

  • Active. Navigating yourself means you have more room to manoeuvre and try to beat traffic (the market) using your driving skills, road knowledge, and tools like maps. However, actively trying to beat everyone else can be risky. You may come across an unexpected roadblock setting you back further than if you’d just followed the rest.
  • Passive. You set your desired destination and sit back. You’ll be taking the same route as many drivers and may hit traffic, with no way to overtake. But, you’re less likely to end up worse off or relying on tools and skills to get to your destination.

Of course, it’s important to remember that when it comes to investing, you may not reach your desired destination at all. Whether you choose to invest actively or passively, you could end up with less money than the amount you put in.

Which is riskier – passive or active?

This varies based on what you’re investing in. In most cases, passive investing is less risky, because you’re not attempting to outperform the market. Passive investment tends to mean less involvement, which can also reduce your odds of making a costly mistake.

Active investing relies on investing skill, which is needed to beat the market. But this also invites human error or poor judgement to play a role. You can lessen the risk involved with active investing by using professional advice or management – which comes with an added cost.

However, there’s always a certain level of risk you need to accept as an investor because there are never any guarantees that your chosen investments will perform or that you’ll make a profit – you can lose money with any strategy.

How do the costs compare?

This is the main area that can set these strategies apart. Securities like passive broad-market exchange-traded funds (ETFs) can be much cheaper than actively managed funds.

The difference may only appear small in percentage terms, but it can significantly impact the overall value of your portfolio over time.

To give you an idea about costs, here’s what a typical range of charges can look like with an example of each strategy:

  • Passive investing cost. ETFs or index funds managed passively can have a total expense ratio (TER) between 0.02% and 0.2%.
  • Active investing cost. Mutual funds, investment trusts, and other actively managed investments can come with a TER of between 0.5% and 1%.

What's a TER?

A TER is calculated by adding up the management fees, operating expenses, trading costs, and any additional costs of running an investment fund and then dividing this by the total value of the fund’s assets.

If you invested £10,000 in a fund with a 5% average return over 10 years, if the TER was 0.2% you’d pay a total of £307 in ongoing costs. If that TER was 1%, under the same scenario and conditions, you’d pay £1,487 in ongoing costs.

One important thing to note is that if you’re an active investor picking your own stocks and shares, this can be more cost-effective if you use a cheaper platform. Most stocks don’t involve ongoing charges. So once you’ve paid a commission to buy shares, that’s it. But if you have even a cheap passive fund, you’re more likely to pay an ongoing charge for as long as you hold the shares (and which will grow as you invest more).

Active investing: The lowdown

Actively managing your portfolio means using all the tools at your disposal to try to maximise your returns (or paying an expert to do this for you).

Examples of active investments include securities such as:

  • Investment trusts
  • Stocks, shares, and bonds
  • Unit trusts
  • Managed investment funds or mutual funds
  • Hedge funds

Active investing can be more time-consuming. This is because researching stocks and shares yourself, or researching funds and managers, can take effort. If you want to invest actively, choosing the right platform is vital.

Look for a platform that offers:

  • Low fees and commissions for active investors
  • Tax-efficient accounts like a stocks and shares ISA or SIPP
  • A choice of DIY portfolios or actively managed portfolios (like IG’s Smart Portfolios)
  • A wide range of shares, funds, and investment trusts, as this increases your chance of finding assets that suit your goals
  • Learning materials so you can educate yourself
  • Research resources such as an economic calendar, video explainers, expert interviews, stock fundamentals research, and in-depth market analysis

Who does active investing suit?

This way of investing best suits someone who:

  • Is willing to spend time researching and managing a portfolio
  • Is comfortable paying higher fees in the hope of higher returns
  • Wants to actively participate in their wealth-building journey

Pros and cons of active investing

  • There’s a possibility you could outperform the market.
  • It’s possible to get expert management for a competitive fee.
  • You’ll likely become a much more educated investor.
  • It can be more time-consuming and involve more risk.
  • Costs and fees can be more expensive.
  • You’ll need a comprehensive investing platform with options, tools, and flexibility.

Passive investing: The lowdown

This strategy is more of a slow-and-steady approach. Your aim is consistent growth rather than trying to outpace everyone, but there is still risk, of course.

The most common way of passive investing is to use low-cost, broad-market ETFs. Once you’ve chosen a fund (or multiple funds), you’d typically invest regularly, regardless of market conditions or stock performances.

By definition, you’ll never beat the market. However, lower fees mean you get to keep more of your returns. And some major stock markets’ long-term performance has still led to pretty significant growth (though of course that’s no guarantee).

Other common ways of investing passively can include putting money into assets such as:

  • Bonds
  • Index funds
  • Mutual funds (that aren’t actively managed)
  • Dividend-paying stocks
  • Property (perhaps using a real estate investment trust (REIT)

Who does passive investing suit?

This investing strategy best suits someone who:

  • Doesn’t have the time or energy to keep on top of their portfolio or what’s going on in the economy
  • Wants to keep their costs as low as possible
  • Is aiming for steady, consistent gains and finds simplicity appealing
  • Isn’t interested in taking on more risk than necessary

If you decide passive investing is for you, using the right platform is also important. Ideally, you’ll want somewhere that offers cheap (or free) regular investing for shares or funds. You’ll also probably want a straightforward platform that’s easy to understand.

The whole point of passive investing is simplicity and lower costs. So, if you pick a complex platform or one with high fees, you’ll cancel out the best passive benefits.

Pros and cons of passive investing

  • It can be a cheaper and simpler way to invest.
  • You’ll still need to do some research, but there’s less ongoing maintenance.
  • Creating a diversified portfolio is easy, which can lower your risk.
  • Less risk can mean lower rewards.
  • It’s unlikely ever to beat the market (because most funds mirror the performance of a benchmark index).
  • Lack of flexibility or ability to grow your experience as an investor.

Bottom line

This is all about finding out which method best suits your personality and investing goals, and how much risk you’re comfortable with. Remember, it’s also possible to create a portfolio with a blend of strategies.

For example, you may use passive investments as a foundation and then pick active investments like stocks or managed funds to give your portfolio some extra va-va-voom. You can always change how you like to invest later down the line. There’s no need to make a lifelong commitment and marry a strategy. Just make sure you’re investing actively or passively in a way you’re comfortable with, using an investment platform that best suits you.

Frequently asked questions

This article offers general information about investing and the stock market, but should not be construed as personal investment advice. It has been provided without consideration of your personal circumstances or objectives. It should not be interpreted as an inducement, invitation or recommendation relating to any of the products listed or referred to. The value of investments can fall as well as rise, and you may get back less than you invested, so your capital is at risk. Past performance is no guarantee of future results. If you're not sure which investments are right for you, please get financial advice. The author holds no positions in any share mentioned.

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