For those new two investing, there are two primary strategies you can use in the quest to grow your account. There’s nothing wrong with using both, but most investors will sway to one side or the other. The two strategies for investing are active and passive.
So, what are the differences between these two investment strategies, and why should you care? After all, the chances are you’re only getting your feet wet in the markets now – and will it serve you to understand the difference between the two?
Yes, understanding everything you can about investment strategies is the key to success. The more you learn about investment, the greater your opportunity to profit from price action movement in the markets.
In this article, we’ll look at the difference between active and passive investment strategies. Our goal is to help you understand the nuances involved with both so that you can make informed investment decisions with your money.
What Is an Active Management Strategy?
An active management strategy is where a trader or fund manager actively trade the investment account. In this case, you might be a day trader or fund manager that places trades on a daily or weekly basis. You analyze your accounts daily performance and look for active opportunities in the market to grow your account.
Active management strategies allow the trader or fund manager to remain flexible in their investment decisions. They look for catalysts that cause markets to move, such as news stories that influence other trader’s decisions when allocating money to the market.
When we compare an active strategy with a passive one, the trader or fund manager has much more room to work in the account. They have no limitations on what they can buy or sell, other than the overall trading strategy they follow. However, active managers can invest in a broad range of funds, indices, stocks, bonds, and currencies.
In most cases, active managers take short-term to medium-term positions that can last anything from a few minutes in a trade to a few weeks.
With an active strategy, you also expose your account to more risk in the form of market volatility. By taking a short-term position in the market, your account has a higher risk of sustaining a substantial loss from movements in price action.
Stops are typically tighter on price movements, and price targets are smaller. As a result, you can place far more trades when we compare it to a swing or long-term investment strategy. As a result, you get more opportunities coming across your desktop and charts, but the risk involved with finding a winner is much higher.
Active management strategies suit players that are both knowledgeable and experienced in market operations. Most of them are day traders that spend years honing and refining a trading strategy that produces consistent results.
What Is a Passive Management Strategy?
Passive investment strategies are almost the identical opposite of active management strategies. With a passive approach, you focus on long-term investments. Most passive investors leave their money with a fund manager that buys and sells a range of assets on the financial markets, including stocks, bonds, ETFs, currencies, and commodities.
The passive management strategy relies less on technical analysis of price movements and instead focuses on a company’s fundamentals as a gauge for future returns. As a result, a passive manage might find themselves in a position that lasts for months or years before they cash out of the investment.
Passive management comes with lower investment fees because the manager is not trading the account as frequently as an active manager. However, they also have less risk involved with the positions they take.
Since passive managers are typically investing for the long term, they are not as concerned with price volatility in the market. Instead, they focus on the trend of the asset or index they’re investing in with their account. Therefore, if there is a sudden price drop in stock due to the company announcing a secondary offering, a passive investor does not concern themselves with the news.
However, such an announcement could freak out any active investor, forcing them to decide to sell the stock, or possibly add to their position. Passive investors also typically take “long” positions in assets. In other words, they almost always expect the asset to increase in price on an upward trend.
Active investors might go long or “short” on a stock, where they bank on the price action of the asset moving downwards. Overall, passive investment was a popular strategy when markets were only heading up. Over the last 10-years, passive strategies have shown investors excellent returns.
However, in recent years, market volatility is in a space where the fundamentals no longer make much sense when investing in a company, and active strategies are paying higher returns to managers.
Portfolio Management Strategies – Active Vs. Passive
What are the key differences between active and passive investment strategies? Which one should you start with, and why? Let’s unpack everything you need to know about where to place your money when you start investing.
Passive Strategies for Investment Newbies
When a newbie investor enters the market, they often start with a passive strategy. An excellent example of this is the use of a 401(k) fund or an IRA. Both of these vehicles pool investors’ money into an account with a large brokerage or investment firm.
The firm then uses a fund manager to manage the operations on the account. The manager decides which stocks, bonds, and ETFs to invest in, and the investors have no say on what the fund manager does with their money.
This hands-off, passive approach to investing is popular with newbie investors that don’t have the skills and experience to trade the markets themselves. They rely on the expertise of the find manage to make prudent investment decisions on their behalf.
In most cases, the fund manager is taking long positions in assets geared for long-term exposure. Therefore, the fund manager doesn’t have much concern if the stock tanks by 10% overnight, as they are in it for the long haul, and they might expect the price to recover.
Passive strategies focus on the trend, not on intra-day moves in the price action of the asset. Therefore, they don’t rely on any technical analysis when reading charts. The hands-off approach is popular with newbies to the market because they don’t have to remain accountable if the asset plunges, and they lose money.
Active Strategies for Investment Newbies
Some newbies to investing decide to take an active role in managing their investment affairs. After all, we’ve all seen movies and series like “Billions,” where traders can make a fortune in a single day. The thoughts of turning a 150% profit on your account in a single morning session behind a trading station leave most people salivating in excitement.
However, the reality is that it takes years to learn how to trade the markets correctly. As a day trader, you might place several trades within the same day, and you rarely hold any open positions overnight. You’re relying on intra-day price volatility to provide you with opportunities to trade. Sometimes the market gives you a return, and sometimes it punishes your account with a loss.
The key to successful active management of your account lies in your investment or trading strategy. “Buy the dip” is a popular investment strategy for momentum-based day traders.
With this strategy, you look for stocks that are receiving momentum from buying or selling pressure in the market. You hope that other day traders notice the opportunity and jump in on the same trade as you, causing a rise in the price action of the asset.
If you enter and exit at the right times, you stand to make a profit. However, in large, most traders end up losing using this strategy – primarily because they can’t handle the emotional rollercoaster involved with seeing the price move up and down.
Even the best traders in the world feel their emotions take them for a ride when a stock they were expecting to rise suddenly drops through the floorboards. To be successful with an active day trading strategy, you need a will cast from iron and a strategy that you backtest to ensure it works.
In short, there is far more chance that you’ll end up blowing up your account and losing everything if you take an active management strategy, and you try to manage it yourself as a newbie.
Is the Stock Market Efficient?
Some experts state that the Federal Reserve has stopped the natural efficiency of the stock market price action. They say that the last 10-years of “Quantitative Easing” (QE) led to a change in market efficiency, skewing price discovery.
The Fed injected trillions of dollars into the capital markets in the wake of the financial crisis. However, instead of this money going to its intended purpose, it found its way into the stock market. Therefore, the Feds money printing scheme, combined with low-interest rates, led to the biggest financial bubble in history, as the S&P500 and Dow Jones both continue to make new highs.
It’s for this reason that many passive investment firms are shutting up shop and returning investors their money. The world’s best hedge fund managers now state that they are no longer able to maintain passive investment strategies in recent years as the Federal Reserve stopped injecting liquidity into the markets.
In short, the Fed took away the punch bowl, and the party is coming to an end. Many reputable passive investors like Warren Buffet and Stanley Druckenmiller, are starting to release stories to the media of how they are out of the markets and allocate their investment portfolios to cash.
The Threat of a Market Crash
It’s for this reason that more investors are moving wither to cash or active management strategies in recent months. Unfortunately, this is not a good sign for investors. When the big boys lose confidence in the market, it starts to shake the certainty of all investors involved with managing passive strategies.
Some experts are even calling for a market crash. In such a case, passive strategies would not be able to get out of the way when the market falls, and they can expect to see their money evaporate as the market plunges into the abyss.
Speak to any investor worth their salt, and they’ll tell you that the market has been bracing for a crash since 2016. The Federal Reserve, ECB, and PBOC flooded the world with cheap money in the wake of the financial crisis.
As a result, the world is currently experiencing the biggest credit bubble in history, with a gargantuan $80-trillion in global debt weighing heavily on the shoulders of the markets. Eventually, the markets will feel the effect of tightening liquidity conditions in the repo market, and we can expect this to be the catalyst for the next big market crash.
If a 2008-style crash were to occur, it would ruin passive investment strategies.
However, active managers might not feel as bad an effect on their accounts in such a situation. Since they’re typically taking intra-day positions, they don’t have any long-term exposure to drops in asset prices or a market crash. In fact, traders might capitalize on shorting stocks that are falling during the crash.
Active Vs. Passive Investment – Which One Is Right for You?
So, which investment strategy suit you best? There’s no reason why you can’t do both. While everyone dreams of being in the position to manage their investments, it’s going to take some time to learn how to trade and develop a trading strategy.
In the meantime, there’s nothing wrong with opening a passive account with a financial firm.
Sure, you might have more risk of a market crash than with an active strategy. However, markets move in cycles, and it will eventually recover after a crash. Start your investment career by looking into passively managed funds, and then branch out into active strategies as you gain experience.