Active Investing

Updated on April 9, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What is Active Investing?

Active investing is an investment strategy wherein frequent buying and selling of securities takes place to earn short-term profits. Its sole purpose is to outperform a benchmark index. So, active investing strategies are followed when the returns required must be greater than the returns of an index fund.

Features of Active Investing

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Active Investing (wallstreetmojo.com)

Active Investing is a high-risk and high-return strategy though passive investing is a low-risk and reasonable-return strategy. Unlike active investing, passive investing is a “buy and hold” investment strategy which aims at making long-term profits. Moreover, passive investing focuses on matching the returns with the index rather than outperforming it.

Key Takeaways

  • Active investing aims to earn short-term profits by outperforming the benchmark indices. It involves swing trading strategies wherein multiple buying and selling transactions are carried out in a short span of time.
  • Active investment managers constantly monitor the stock prices throughout the day. Their goal is to benefit from price changes.
  • Active investing is different from passive investing which is a “buy and hold” investment strategy. Passive investing is less risky, less costly, and yields moderate returns.
  • Active investing requires qualitative and quantitative analysis before making decisions. The fund managers identify the right time to buy and sell securities.

Active Investing Explained

Active investing requires constant monitoring of market conditions before making the buy and sell decisions. This implies that the investment manager or the investor needs to watch the movement of security prices throughout the day.

Active investors follow the given strategies:

  • They use a well-calculated and quantifiable approach to identify the entry and exit points for each investment. This implies that an in-depth analysis of each investment is conducted before decision-making. Such analysis involves numerous metrics for evaluating a security rather than relying on just one or two factors.
  • They avail the services of portfolio managers and research analysts to earn higher returns than the benchmark indices like S&P 500, Dow Jones Industrial Average, NASDAQ Composite, etc.
  • They take advantage of the emerging opportunities and respond to the changing market conditions actively. No investment is undertaken based on emotions or the historical performance of the security.
  • They believe in following swing trading strategies. Such strategies focus on generating wealth by holding a security for a few days or a few weeks. Swing traders profit from the changing prices of a security. If swing trading is carried on consistently, it returns large gains on investments.
  • They customize portfolios to meet their goal of generating wealth in a short period of time. A portfolio is built based on the investor’s risk tolerance and investment objective.
  • They incur additional expenses (like commission) as the number of trading transactions carried out in a day is too large. Moreover, a hefty fee has to be paid to fund managers and research analysts. This is the reason active investing is costlier than passive investing.

Active investing is highly volatile (or risky) as the stock market changes with every small or big change in the economy. This is the reason this type of investing is not recommended when constant returns are required over a longer period. For instance, active investing is not suitable for arranging funds for retirement. Instead, a savings plan or fixed deposit would be a better option for such a purpose.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Example

In May 2022, Morningstar Direct, an investment analysis firm, claimed that the holdings of passive retail investors have exceeded those of active investors. Precisely, as of March 31, 2022, passive investors hold $8.53 trillion in mutual funds, while active investors hold $8.34 trillion in active investments. The reasons active investments could not outperform passive investments are stated as follows:

  • The foremost reason is the high fees and costs. The fees of passive investing is 0.43% lesser than that of active investing. This percentage can help save trillions of dollars when the investments are huge. This is the reason passive investors saved $38.6 billion in fees.
  • Another reason is that the initial annual costs incurred for owning index funds have been much lower than that of active investments. For instance, the exchange-traded fund (ETF) of Vanguard 500 costs only 0.03%, which was earlier 0.20%. The initial purchasing costs have declined to meet the low-cost offerings of the competitors.
  • Active investing lags behind passive investing because, for several years, the active investments have underperformed the benchmark indices. For instance, 85.1% of active large-cap investments underperformed the S&P 500 in 2021. This low performance of active investments has pressurized the active investment managers to make improvements in their strategies.

Despite the good performance of passive investing over active investing, one cannot guarantee success, especially in the current times of the pandemic (Covid-19).

Active Investing vs Passive Investing

The differences between active and passive investing are as follows:

DifferentiatorsActive InvestingPassive Investing
DescriptionIt outperforms the benchmark indices.It matches returns with those of the benchmark indices.
PurposeIt is undertaken to earn short-term profits.It is undertaken to earn long-term profits.
StrategyIt involves frequent buying and selling, usually based on price fluctuations.It involves buying and holding investments based on research and analysis.
CostIt is more costly and expenses include commission, fees, taxes on capital gains, etc.It is less costly as one need not avail of the services of fund managers.
Risk and returnIt is highly volatile, but risks can be diversified by holding portfolios of different assets. High risks give high returns.It is not so volatile and diversification is allowed. Low risks give low (or moderate) returns.
LossIt is possible to minimize losses arising from a downturn of the stock market.It is difficult to minimize losses as passive funds fall with a downturn of the stock market.

Frequently Asked Questions (FAQs)

1. Why is passive investing better than active investing?

Passive investing is preferred over active investing due to the following reasons:

– The trading volume is lower in passive investing. Consequently, the expenses incurred on trades are also low.
– The charges and the fees of the fund manager are almost absent. This is because passive investing need not necessarily require the expertise of fund managers.
– The passive investor need not spend efforts on monitoring stock prices consistently. Short-term price fluctuations are not captured since the goal is to make profits in the long run.
– The risk of investing in passive funds is lower. One can earn reasonable returns by bearing lower risks than active investing.

2. Why is active investing better than passive investing?

Active investing is preferred over passive investing for the following reasons:
– It can bring in higher returns though they come with high risks and high costs.
– This type of investing is flexible and gives good opportunities to chase high returns in the stock market.
– The active investing fund managers can diversify their mix of assets and focus on the most promising investment. Skilled managers can make a lot of money with AI.

3. Can active investing beat the market index?

Active investing can beat the market index at times but not always. Therefore, even if it is performing well in the current scenario, there is no guarantee that it will keep beating the index in the future as well. Moreover, active investing need not work well in all kinds of markets (like a developing economy) and all phases of an economy (like a recession).

For this reason, most of the times, the investment experts suggest following a blend of active and passive investing strategies. One must invest based on the risk tolerance, goal of investment, availability of dedicated funds, age of the investor, etc.

This article has been a guide to Active Investing. Here, we explain the strategies of active investing along with examples and its differences from passive investing. You can learn more from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *