Active investing vs passive investing: Which is better if you want to get rich?

One common trait amongst the rich is they invest their money. They know better than to keep all of their savings in cash and let it lose purchasing power over time due to inflation. Instead, they put their cash to work so their money can turn into even more money. Makes sense, right?

Nobody can become an investing expert overnight, but everyone has the opportunity to learn something new about investing every day. I couldn’t explain the difference between stocks and bonds for the longest time when I was younger, but now I can talk about anything from ETFs, options, bank debt, CDS, MBS, ETNs, swaps, futures, forex, REITS, structured notes, etc. We all have to start somewhere.

One topic I’ve found interesting is the difference between active investing vs passive investing. There’s no wrong or right way to invest, yet some people wind up making so much more than others. The possibilities of how to construct an investment portfolio are infinite, which is pretty cool.

Investing doesn’t have to be rocket science, but everyone should strive to get a solid grasp on their own risk preferences, preferred asset allocation and investment style. Let’s take a quick dive today into active versus passive investing.

Active versus passive investing

Ok so in a nutshell, active investing is very hands-on whereas passive is very hands-off. Active investors, aka engaged investors, often strive to outperform market indexes over time. Easier said than done. One way active investors do this is by constructing portfolios that are customized and unique in comparison to the indexes they are trying to outperform. So for example, they might choose to overweight specific stocks, sectors or themes.

Passive investors on the other hand tend to buy and hold index funds with a long-term focus. They aren’t trying to become the next stock picking guru. You can kind of picture passive investors as those who steadily follow the herd, while active investors like to break out and blaze their own trail.

So which approach could make you richer? If you’re super savvy, you’ll probably be able to make more as an active investor but you also risk blowing yourself up in the process. The stock market is unpredictable and even the smartest investors make mistakes. And always remember that downturns are inevitable, but history has shown that in the long run the markets eventually rebound and recover.

Both active investing and passive investing have their own pros and cons, which is why many investors choose to have a blend of both styles. I personally use both styles myself and although I’m pretty engaged with the markets and like to make my own trading decisions, I have a fair amount of passive investments. Whichever style or blend you pick, it’s important to think long-term and develop your own a plan for how to respond to fluctuating markets and lifestyle changes.

Pros and cons of active investing

If you enjoy watching the markets, look forward to earnings season, like playing an active role in the decision-making process of your investments, and want to overweight ideas you strongly believe in, you’ll probably favor active investing.

Transparency is super important to active investors and is a great benefit. There are a lot of benefits of investing in companies/stocks/themes that you are very familiar with. Plus it’s always good to have full disclosure of exactly what you’re investing in. Active investors are very aware of where there money is going.

Another benefit is they have a lot of control over the frequency and types of trading transactions in their portfolios. Having personal ownership provides engaged investors the autonomy to decide what to invest in and when.

But deciding what to buy, when to take profits, cut losses, and rebalance takes research and skill if you want to do it well. So while this approach can provide active investors with the opportunity to achieve alpha, the downside is their predictions could simply turn out to be wrong. And that can mean large losses depending on one’s exposure.

Another con of active investing is that transaction fees can get pretty expensive with frequent buying and selling. It’s always important to monitor how much you’re paying in commissions, markups, sales loads, margin fees, etc.

Pros and cons of passive investing

If you prefer a hands-off, set it and forget it approach to investing, you’ll likely prefer passive strategies. I think it’s always better to invest your money into assets that can be managed by a robo-advisor or simply held long in your brokerage account versus not taking any action at all. Take a look at this helpful guide on the best robo-advisors to help you get started.

Passive investing is also an easy way for newbies to get their feet wet. Investing can feel very intimidating if you’re just getting started and jumping into an active strategy first usually isn’t the best idea.

A passive approach on the other hand, is a good way to learn about the markets, steadily grow your balance and gain confidence over time. It’s also a good way to ride out volatility swings and shield yourself from impulse trading. Trading compulsively on emotions usually just leads to regrets like selling low and buying high.

One thing to watch when passive investing in index funds is that as individual stocks perform well and their market cap increases, these stocks can get a larger weight in their respective index. The downside of this is investors who are too hands off can become overly exposed to yesterday’s top performers versus rising star stocks that could hold better value and have higher growth potential.

Even though passive investing usually doesn’t outperform its respective index, it’s generally less risky than active investing.

Who you are can influence how you invest

Have you ever thought about how some of your personality traits impact your savings habits, cash utilization, investment style and level of engagement with the markets? Looking back on my life, I can definitely see a correlation between who I was/am and how I’ve managed my money and investment portfolio.

When I was in my early 20s I was rather timid in personality and also super passive with investing. As I’ve gotten older, I’ve become more confident in a lot of areas, more active in lifestyle but also laid back. As a result, my investment style is no longer fully passive. Now it’s a fluid blend of both active and passive investing, similar to my personality and lifestyle traits.

Do you have a preference for active investing vs passive investing? Think about who you are as a person to help find an investing style you’re most comfortable with whether it is fully engaged, totally passive or a happy blend of both.

Don’t be afraid to try something new and adjust your investing style over time as your lifestyle, investment knowledge and goals change. Making regular contributions to your accounts, no matter how large or small, is a key to getting rich. Stick with anything long enough and you’ll be surprised with what you can accomplish.

Recommendations

If you want to become financially independent and have more money, get curious and proactive about investing. Even if you are passive in personality, please do not procrastinate when it comes to opening a retirement account or an investment account. Start investing as early as you can and you’ll be so much better off than if you didn’t save at all or just held cash.

I ran into a 31-year-old woman at a networking event the other day who still hasn’t opened a retirement account and I wanted to literally shake some sense into her. I opened my first investment account right after college and opened my first retirement account in my early 20s. I still wish I had started even sooner! I didn’t have much money in the beginning, but my accounts wouldn’t be anywhere near as large as they are today if I had waited years or decades to get started.

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Untemplaters, do you have an open retirement and/or investment account? Do you consider yourself more of an active investor, passive investor or a blend of both? Does your lifestyle and personality line up with your investment style?