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The difference between active and passive investing

Navigating the stock market can be difficult. Here’s a look at the pros and cons of passive and active investing.

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Investing money can be an excellent way to generate some passive income and make your money work for you, but navigating the stock market might make you feel you need a degree in accounting. Let’s take a closer look at active vs. passive investing, and the pros and cons of each.

What is active investing?

Active investing, as its name suggests, means the investor takes a hands-on approach to their investments. The stock market is continually changing — the prices rise and fall depending on how a particular company is doing, and those changes affect the portfolios of active investors. The goal of active investing is to make as much money as possible by buying when prices are low and selling when they are high, so an active portfolio is always changing.

Active investing requires a deep understanding of the fluctuations that take place when the market is open. Stock market analysts study the patterns of these market changes and make predictions based on that information. This isn’t something the average person can approach on their own. If you’re interested in active investing, hire a portfolio manager that employs a team of analysts to help you make the most of your investments.

What is passive investing?

Passive investing is the opposite of active — instead of buying low and selling high over and over again, passive investors buy stocks and hold onto them. They don’t need to anticipate the market’s every move because they’re not going to sell their holdings according to the whims of the market. Instead of relying on the big paydays that come with selling stocks, these investors generate passive income from dividends and interest over time.

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Some passive investors rely on index funds or robo-advisors, but they are definitely in the minority. Index funds make up less than $1 out of every $5 spent on the stock market. Many who specialize in active investments believe robo-advisors and index funds are doomed to fail, but this style of investing will be around for a while longer.

Active investing pros and cons

Let’s take a look at some of the pros and cons of active investing.

  • Pro — Flexibility: The market is continually changing, and sticking to a passive investment plan could cost you money in the long run. Active investing gives you the flexibility to buy and sell to maximum effect as the market shifts.
  • Con — Cost: Active investing is expensive, even if you have significant returns coming in every year. Portfolio managers usually charge an annual fee for their services, even if you’ve lost money, and they may also take a cut of your profits off the top.
  • Pro — Tax Breaks: Even losses can be beneficial for active investors. They can stack their stock market losses against their taxable income, which reduces year-end tax bills.
  • Con — Initial Investment: You’re not going to get into active investing without a large bank account to back you up. These portfolio managers can afford to be picky about who they choose to work with, and may require substantial initial investments — $250,000 or more — from a new client.

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Passive investment is one of the cheapest ways to take advantage of the stock market. (Photo by GaudiLab via Shutterstock)

Passive investing pros and cons

What about the pros and cons of passive investment?

  • Pro — Lower Costs: Passive investment is one of the cheapest ways to take advantage of the stock market. There are very few fees, no overhead costs like you’d incur by hiring a portfolio manager, and you don’t need to make a substantial initial investment.
  • Con — Fewer Returns: Since you’re not buying and selling as the market changes, your returns won’t be as high as they would be with active investment. It’s an excellent option for anyone who wants to leave money in the market for the long haul, though, with steady passive returns trickling in every year.
  • Pro — Predictability: The stock market is anything but predictable, but with passive investing, you will always know what your money is doing and where it is invested. For someone who is investing for their future, rather than for the short-term payday, this predictability is an absolute pro.
  • Con — Fewer Options: Passive investing may limit you when it comes to what companies you can invest in. Most index funds focus on the top companies in a given area, preventing you from taking advantage of new startups that may just be entering the market.

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Whether you choose to actively or passively invest your income is entirely up to you. Hopefully, these pros and cons will help make that decision a little bit easier.

(Featured image by Zephyr_p via Shutterstock)

DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation for writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.

Kayla Matthews is a technology blogger who regularly contributes to Inc.com, MakeUseOf and The Gadget Flow. Follow Kayla on Twitter or check out her technology blog, Productivity Bytes.

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