Comparing the Pros and Cons of Passive and Active Investing
As seen on the WJAR NBC 10 Smart Advice Series
One of the most visible discussions in the investment world today is the comparison of active and passive asset management. The premise is that “passive” investing – selecting securities that track an underlying stock or bond index – could cost less and could potentially perform better than the active approach, however, other factors are involved. What are the pros and cons of using passive or active approaches for investors, and which is right for you?
As with many aspects of investing, the answer is that it depends on your individual goals and objectives. Passive investing can provide investors with a low-cost, efficient means to effectively track a given financial index. However, this approach can also create unintended concentrations in certain investment sectors, particularly during times of rising market valuations. It could also eliminate opportunities for outperformance in rising or falling market conditions – investors in some passive index funds, for example, could do as well as the overall index, and can provide low-cost exposure to various market segments. Passive investing could also reduce the ability for investors to respond to changes in sector valuations, company valuations, or interest rates.
An active management approach attempts to add value through the selection of individual securities, often based on fundamental analysis, and by the weighting of different investment sectors. However, there is no guarantee that active management will outperform passive indexing, and the cost of active management can be higher than that of passive management. Potential benefits of this approach could include the ability to limit exposure to certain sectors, industries or companies; maximization of tax efficiency strategies by managing capital gains and losses throughout the year; and management of liquidity, leverage and profitability. An active investment approach could also differentiate itself during periods when securities valuations are based more on individual fundamentals, rather than on a general “rising tide” that lifts all boats equally.
As with many aspects of wealth management, the appropriate approach depends on your individual facts and circumstances. In conjunction with a careful analysis of your time horizon, risk tolerance and financial objectives, both active and passive methods can work together to deliver the best of both worlds while compensating for the downsides of each. Properly constructed, a customized investment portfolio can combine both active and passive management strategies to offer a form of diversification and give investors the potential to achieve their overall financial goals.
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The information provided does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, portfolio manager, attorney or tax professional regarding your specific investment, legal or tax situation. Stock markets and investments in individual securities are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investing entails risk, including the possible loss of principal.