As investors begin to build and manage their portfolios, they must also decide on the investment approach that best fits their goals and objectives. The different styles of investing can range from fully active, where investors make every decision about each asset, to passive/managed where much of this work is done for them. When considering which approach is the right fit, it’s important to carefully consider how much time and effort is required. What is active investing and what are the costs and benefits for everyday investors?
Active investing is an approach in which investors buy and sell individual securities based on the attractiveness of each asset. Active investors can have a variety of objectives, but it’s common they aim to beat the market by achieving higher returns and/or lower risk compared to a broad index or some other measure of market performance. Active investors employ many strategies to try to accomplish this such as “security selection,” i.e., choosing the stocks that are attractive, and “tactical trading,” which seeks to take advantage of shorter-term market opportunities. When employing active strategies, investors usually have full control over what they own and when.
In contrast, passive strategies often track total market performance or a large subset of the market. For example, the S&P 500 index tracks the performance of the 500 largest companies listed on exchanges in the United States. Passive investors typically also buy and hold investments for longer periods. The benefits of passive investing are its simplicity and low cost. However, passive investing does not typically allow investors to take advantage of stocks that they believe to be more attractive or to react to different market environments in the same way they might if active investing .
In short, active investing relies on ongoing analysis and stock picking, while passive investing is more of a “set it and forget it” approach.
So, what makes a stock or bond more attractive to an active investor? This can depend on many factors which require investors to be educated about and aware of financial metrics. For this reason, the complexity of active investing can be daunting to many newer investors since it requires that investors be well-informed, disciplined, and have timely analysis available to make decisions. However, these challenges can be alleviated by technology that educates and provides real time data to investors. Today, investors have access to market data and research reports that just a couple of decades ago were only available to highly sophisticated professional investors.
For example, some investors may focus on fundamental research such as the valuations of various stocks. The price-to-earnings (P/E) ratio, for instance, compares the price of a stock to its earnings-per-share (EPS). Stocks that have a high P/E are considered to be more expensive than those with lower P/E’s. Thus, some investors may choose to consider stocks that are cheaper against their peers, against the broader market, or against their own history. Similarly, investors may focus on how quickly a company’s EPS is growing.
Learning the many ways to analyze the market, economy and individual stocks and bonds is a process that can be rewarding for those who are interested. Although active investing may require more work and can incur higher trading costs, some investors choose this approach because it also has the potential to outperform the market (although there is never a guarantee).
For new investors, choosing whether to pursue an active or passive approach is an important first step. Active investing may not be for everyone since it requires a commitment to learning how to evaluate individual stocks and bonds, and the costs and risks associated with them. However, those who are interested in doing so can create highly tailored portfolios based on their own research and objectives.