With more people dipping their toes into investing, the passive versus active investing debate is again in the spotlight.
Here’s everything you need to know about passive investing, from how it works to the advantages and risks.
What is passive investing?
A passive investor takes a long-term approach to the value of their assets.
This is often called the ‘buy and hold’ mentality, in which investors expect to buy shares or stocks and keep them for a while.
Rather than attempting to beat the market as an active investor might, a passive investor often hopes to replicate the market’s growth over time.
Passive investing doesn’t tend to deliver short-term wins, but long-term successes can be considerable, although risks may need to be managed over extended periods.
How does passive investing work?
Some passive investors operate in property or a similar tangible industry.
Many put their money in index funds or exchange-traded funds (ETFs).
This way, they can be relatively hands-off about their money management, letting things sit and grow.
According to 2022 data from the Investment Association, passive tracker funds comprise around 20% of the industry, equating to almost £280 billion in value.
To reiterate, passive investors don’t want to beat the market - they simply aim to track its success.
This can make passive investing an accessible strategy for beginners – especially when passive options are often managed for you and don’t require regular trading of stocks and shares.
Passive investing vs active investing
So, what about active investing? It's a more direct approach based on a desire to outperform the market.
A portfolio manager usually handles an active investment strategy.
It can be more flexible and tailored, but it can also create more work and come with higher fees.
According to IFA Magazine, just 13% of active funds in the UK outperformed the average passive fund in 2022, showing that active management doesn’t always mean higher returns.
The pros and cons of passive investing
There are many benefits to passive investing including:
- It’s less risky if you can wait out periods of market volatility and is likely to perform similarly to the tracked index.
- There are lower management fees compared to active strategies and potentially lower tax.
- Passive investing requires less commitment and knowledge from the investor.
While there are many advantages, there are some downsides to consider, including:
- It won’t usually do better than the market and outperform in the way active investing can.
- It is informed only by the index’s price changes, so no further research is undertaken.
- Passive investing is long-term. Some investments take decades to come to fruition.
The pros and cons of active investing
If you’re considering active investing, there are many advantages such as:
- Increased flexibility as there’s no need to follow a specific index.
- Short sales and put options may lower your exposure to risk.
- By working with a portfolio manager, you can ensure your investments are right for you.
However, there are some disadvantages to active investing, including:
- The potential for underperformance or human error is higher than passive investing.
- The management fees associated with an active investment strategy can be steep.
- Short-term investments tend to be less tax efficient as they won’t be counted as long-term capital gains.
How to get started with passive investing
You have many options if you’re wondering how to start passive investing.
You could make a tangible long-term investment like a property purchase or invest in an index fund or an ETF.
Regardless of what you choose, your strategy should focus on the long-term, minimising mistakes and keeping fees low.
It’s worth considering:
- Defining your investment goals clearly.
- Building a portfolio of appropriate passive investments that align with your goals.
- Having patience and not focusing too much on short-term market fluctuations.
- Remaining focused on the long term and reinvesting dividends where possible.
Could you combine a passive and active approach? This is both possible and common, as it can diversify your portfolio further.
But doing active and passive investing means more fees, so you should consider it carefully.
It’s worth getting financial advice before investing your hard-earned cash.
Unbiased can connect you with an FCA-regulated financial professional who can provide useful advice and help you with your investment strategy.