Your Investment Approach: Active vs. Passive
The active vs. passive investing debate is one that rages constantly online.
And while it’s an important topic to discuss, many conversations about active vs. passive investing simply lack nuance.
A lot of people firmly believe that active is bad, passive is good… but then a whole other group believes the opposite.
But like many things, there needs to be more nuance, more detail, and the answer is simply not as black-and-white as we try to make it out to be.
In part three of our series on building your own investment approach (episode 66 on The Canadian Money Roadmap), I took some time to discuss each approach. By understanding more nuance in this conversation, you can better choose the approach that works for your personal investment strategy.
What is Passive Investing?
Active and passive investing are both strategies. They don’t refer to specific investment vehicles or securities—i.e., mutual funds or ETFs are not, themselves, active or passive.
A passive strategy, then, is the idea that you own a broad set of investments. It’s like owning a bit of everything, the good and the bad.
It’s what people try to replicate when they talk about “the market” and how it performs.
One common misconception about passive investing is that it’s less risky than active investing. This isn’t necessarily the case, though. Active investing is simply the idea that you aren’t picking and choosing individual components of your portfolio, but there is still risk attached to it.
Pros and Cons of Passive Investing
There are a few main reasons someone would take a passive investing approach:
Easy to understand and track: You’re buying everything with this approach, so it’s easy to keep track of. If you’re invested in the TSX60, for example, you can simply look up online how it’s doing today.
Low cost: Because there are fewer decisions, trades, and even people involved with passive investing, it’s cheaper to do. A lot of passive investing can be done by computers, so it eliminates a lot of the costs and fees associated with managing a portfolio.
Passive investing is simple and cost-effective.
But if you are someone who wants to make decisions and choices about your portfolio, it might not be the right approach. With passive investing, you’re buying everything, even if it doesn’t align with your values, interests, and predictions.
What is Active Investing?
If passive investing is owning a bit of everything, then active investing is the opposite—you choose specific components of your portfolio to invest in.
The goal of active investing, or intentionally investing in specific things, is to provide a different outcome. This is normally one of two things: to beat the market or decrease volatility. Ultimately, active investors want to try and pick the good stocks and ignore the bad to create an ideal outcome.
Pros and Cons of Active Investing
The main “pro” or reason people choose active investing is because there’s an opportunity to beat the market and have higher returns.
The other main benefit of this approach is that you can be highly selective in what you are investing in. This may be important to people interested in ESG investing or want to avoid owning stocks of a particular company.
On the other side, active investing is incredibly difficult to do, especially over the long term. You or your portfolio manager may be able to pick stocks that outperform in the short term, but maintaining it over a long period of time is much more challenging.
There are two other downsides to active investing:
More expensive: Because you have people actively working behind the scenes on a portfolio, it simply costs more. The portfolio manager’s fees, at times, can be so high they cancel out any potential gains.
Time-consuming: Again, because people are actively involved in choosing and trading specific stocks and securities, it takes a lot of time if you choose to do this yourself.
The Active vs. Passive Investment Grid
The term “passive investing” can be a bit of a misnomer. Almost nothing is completely passive, because there is always some kind of decision-making going on behind the scenes.
Passive philosophies still demand active choices, such as:
Geographic location of your investments
Rebalancing timing
Investment provider
Asset allocation (i.e., strategic vs. tactical)
These are just a few decisions you have to make, even with a passive approach. And because of this, passive vs. active investing should not be seen as a binary either-or option.
Instead, it’s more beneficial to view passive vs. active investing as a grid with two ideas: philosophy and implementation.
With this grid, you have four different outcomes:
Active philosophy and active implementation: This means you’re picking stocks, mutual funds, etc. yourself and consistently trading them to get the best outcome. This is likely to be the least likely way to succeed as it opens a lot of room for human error and mistakes.
Active philosophy and passive implementation: Here you are getting a portfolio manager to pick stocks, mutual funds, etc. for you. So, they’re taking an active strategy towards your portfolio but it’s passive on your end because you’re sitting back.
Passive philosophy with an active implementation: This is similar to factor investing where you pick your assets based on certain factors and then hold them.
Passive philosophy with a passive implementation: This is something that would look like owning a total world fund where companies are weighted by market cap. Many passive investors think they would fall in this camp but it’s much more rare than you might think.
So within these categories, you can see how many ways there are to invest. And, depending on your goals and preferences, you may lean further into one of these four categories.
The important thing to keep in mind here is that, regardless of which option you choose, there is risk. Risk is present simply because you are investing in stocks—it has nothing to do with the strategy you choose.
It’s like the risk of a swimming pool. No matter the size, shape, or color, there’s risk of someone getting hurt or drowning—the risk is the pool.
And it’s the same with investing. There’s an inherent risk because of the choice to participate in the stock market.
So, some people may prefer active and others passive for the reasons outlined here. Skeptics on either side need to know that there are potential benefits to each, and choosing one approach over the other should be aligned with your overall investment approach.
If you want to dive into this topic more, listen to episode 66 of the podcast. You can also check out other parts of this series: stocks vs. bonds and strategic vs. tactical.
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Evan Neufeld is a CERTIFIED FINANCIAL PLANNER® professional in Saskatoon, Saskatchewan and offers both investing and fee-only financial planning services.
*Disclaimer: Any numbers or rates of returns are used for illustration purposes only and should not be taken as fact. Note that the information in this article is current to the time of writing but is not guaranteed as up-to-date past then.
This article and accompanying podcast do not constitute personal financial advice. Evan Neufeld is a CERTIFIED FINANCIAL PLANNER professional in Saskatoon, Saskatchewan, and provides this Canadian personal finance content for educational purposes to the public. You are welcome to contact Evan to receive personalized fee-only financial planning or investment portfolio management.