I just started learning about investing, and some of the terminology is a little confusing. What is the difference between passive and active investing, and which one is best?
When looking at mutual funds as a component of an overall investment plan, many criteria distinguish one fund from another. These criteria include asset class (stocks, bonds, international, and industry sectors), load or no-load (sales charges and/or commissions), and management style. From the standpoint of management style, mutual funds are generally categorized as being either actively or passively managed.
Passive management, a category that includes index investing, is an investment strategy that attempts to replicate the returns of an index or benchmark by owning the same assets, in the same proportions, as the underlying index. For example, a passively managed large cap index fund that seeks to replicate the Standard and Poor’s 500 Index (S&P 500) would own all 500 stocks that comprise the S&P 500 Index.
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Passive management focuses on the assumption that markets are perfectly efficient and stocks always trade at their fair value price. This means no one stock is ever over- or undervalued. This is the primary difference between active and passive investing. Active investors believe that markets are not always perfectly efficient, and there are over- and undervalued stocks that provide different investment opportunities.
Investors utilize passive management because it provides broad market diversification and low relative internal expense ratios. Since passive portfolios do not require managers to expend significant resources researching the market or selecting stocks, passive management tends to be less costly than active management. In addition, since passively managed investments track a market index, those mutual funds benefit from a relatively low portfolio turnover rate. Fewer trades translate into lower transaction costs.
Passive management is essentially a buy-and-hold strategy that results in relatively low trading costs despite the large number of security positions within an index portfolio. Passive investing through an index fund also provides significant diversification benefits since index portfolios hold all the stocks comprising their specific asset class.