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Which is better: active vs passive investing?

Which is better: active vs passive investing?
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Active vs. passive investing: what do the terms even mean, what are the differences, and which is better for making long-term gains? Let’s take a look.

What is active investing?

Unsurprisingly, active investing is about taking a hands-on ‘quick wins’ approach to investments. And unless you’re a statistical or financial whizz with a tonne of time on your hands, it usually means handing over your money to a portfolio (or fund) manager.

Portfolio managers spend their time stock-picking, which means actively investing your cash in the stocks they believe will perform well. The ultimate aim is to choose stocks that will do better than the stockmarket average. In most cases, fund managers use a specific index to base their average on.

An index is simply a collection of firms that represent or share a particular feature. For instance, the FTSE 100 is the collective name given to the largest 100 firms in UK that trade stock.

Because markets can be volatile, fund managers and their teams are likely to be constantly crunching numbers and assessing market performance. All of which makes active investing very time-consuming.

What is passive investing?

Passive investing is investing that aims to be in line with a particular market benchmark for long-term gain rather than quick wins. And instead of stock-picking, fund managers invest your money in a chosen index – like the FTSE 100.

Fund managers can choose to invest in all the firms within a particular index – known as replication. In this case, stock bought is proportionate to the firm’s share within the index. So, if company A made up 2% of (say) the value of the FTSE 100, the fund manager would invest 2% of its fund value in that firm.  

Alternatively, managers can choose to invest using the sampling method. This is when investments are made in just some of the firms in any given index. Naturally, it’s not just a random selection picked out of a hat. Firms are chosen in a way that reflects the given index, but on a smaller level. For example, let’s say renewable energy made up 5% of the index and pharmaceuticals 7%. The fund manager would invest 5% of its fund in renewable energy and 7% in pharmaceuticals.

What are the benefits and risks of each?

Like most forms of investing, when it comes to active vs. passive investing, there are two sides to the coin. Benefits and risks include:

Active investing

Benefits:

  • Flexible – fund managers can choose to invest in firms they believe will increase in value.
  • Agile – managers can react quickly, selling and buying stock according to performance and market conditions.
  • Potentially lucrative – you may earn significant returns if your fund manager has a nose for outperforming stocks.

Risks:

  • Expensive – a managed fund is costly. You’ll need to factor in management fees, commission, and transactional costs. In some cases, expenses could even outweigh returns.
  • Unpredictable – all investments are unpredictable, but they are potentially more so when funds are managed, as it relies on other people’s assessment of the market.

Passive investing

Benefits:

  • Inexpensive – this type of investing is less time-consuming, so management fees are lower. There’s also less buying and selling of stock, meaning fewer transactional costs.
  • Diverse – investing in a whole index or sampling an index gives you a broader spectrum of stock, which can mitigate risk.
  • Transparent – as managers are investing in a specific index, it’s clear how funds are used.

Risks:

  • Limited – simply tracking the market won’t give you the opportunity to earn significant returns.
  • Inflexible – fund managers don’t have the option of reacting to performance, so your funds can be exposed to very general market performance trends.

Which is best: active or passive investing? 

The best investing method for you really depends on your circumstances and your specific goals.

Active investments might well be the right route for you if you have a high tolerance for risk. The potential for gain in a short space of time is also much greater with active investing.  

On the other hand, passive investing might be best if you’re in it for the long haul and prefer to hedge your bets.

Of course, like most things, a little bit of everything is often the best bet of all. For that reason, fund managers often use both active and passive investing.

But, if you fancy dipping your toe in the water and having a go yourself, here are some smart FTSE 100 investments to consider making right now.

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