Can a portfolio be both active and passive?
Whether you are investing on your own or have your hard-earned money with a financial professional, there are two ways your money may be working for you. These two different ways are how you can categorize your investment strategy. They are Active Investing and Passive Investing.
By just looking at the names of these two ways of investing, you may have a clue what they actually mean. You are probably correct, but to explain in financial and investing terms, I will mention what goes on and how it makes these two investment strategies different.
Active Investing Strategy
First, Active Investing can be defined as the ongoing effort to outperform a particular benchmark or the market. When you think of active investing, think of a lot of trading going on, imagine that movie you saw where there are 50 traders sitting with their face practically touching the computer screen and trying to find that next best move. Active investing is the never-ending game of trying to do better than the overall market or a particular benchmark (think S&P 500). You want your returns to be higher than what the S&P 500 will return for a particular year. You want that repeatedly, year after year, month after month. These investment strategies include heavy research, high trading volume (high transaction costs) and an expertise of whatever strategy may be running to outperform. One way to describe an active strategy that is often used, is called a stock picker.
Now as all things in life, there are pros and cons to each of these two strategies. One pro to active investing that you probably get after reading the first few paragraphs, is the chance for better performance. Another being that while being a stock picker, you are going to be spending a lot of time doing research and looking for the next best idea. This research may lead you to findings that you wouldn’t have thought of without it. It can be possible that you may find indicators that something bad may be coming and you can avoid that. That is just one broad example that research can uncover. On the other hand, a possible con for active investing is the opposite of better performance. While actively trying to outperform, you may find yourself selecting wrong investments and leading your portfolio to a chance for worse performance than the market or benchmark you are going up against.
Passive Investing Strategy
Second, Passive Investing which as you can imagine now, is the opposite of active investing. You are not trying to outperform the market, you are not incurring high transaction costs from an active trading strategy. You are simply focused on mirroring the performance of the market or a particular benchmark. It is a sit back and watch your money grow as the market grows type thing. It is a put your money into a time machine and if you do it right, years down the road you will see what it can spit back out to you. You want to build wealth gradually. It is a long-term approach where fluctuations in the market in the short-term shouldn’t bother you like an active strategy may. When you hear the term “Buy and Hold” think passive.
I bet after reviewing these two strategies, you can imagine the pros and cons of passive investing now. Pros for passive investing would be a much smaller chance if any, of worse performance than the benchmark you may be tracking. Also, as the passive investor isn’t doing much research or making many trades, you will have lower fees compared to an active strategy. On the flipside, cons for passive investing may include the missing out of better performance than the market or a benchmark as you are simply mirroring what the overall market or benchmark is doing. Also, you won’t have much insight to research so that will lead you to react with the market, whether up or down.
Which strategy should you follow?
Now, after all that has been said, you don’t necessarily need to be either or. You can be both. You don’t have to designate 100% of your portfolio to either of the two. You can do a percentage to one and a percentage to another. Imagine selecting a mutual fund that will mirror the S&P 500, you allocate 80% of your money to that fund. Now the remaining 20% you can try to conduct research or if you have your money with a professional, they will be conducting the research and can put you into strategies that are aiming to outperform with individual stock selection. In the industry, this is called a Satellite Portfolio.