When it comes to investing, there are generally two different approaches you can take if you’re looking to grow your wealth. You can practice either active investing or passive investing. Both styles allow for financial return, but just in different ways. Whether you’re new to the stock market or you’re an experienced shareholder, it’s important to note the differences between the two. Below, we take a closer look at the pros and cons of each investing style.

If you want more hands-on guidance in devising the right investing strategy for you, consider finding a trusted financial advisor in your area.

How Active Investing Works

Active investing is a strategy in which investors, portfolio managers, or financial professionals aim to outperform the market by actively buying and selling securities based on research, analysis and market trends. Unlike passive investing, which seeks to match market performance through index funds, active investing relies on frequent trading, stock selection and market timing to generate higher returns.

Investors use fundamental and technical analysis to identify undervalued stocks, anticipate price movements, and react quickly to changing economic conditions. While active investing offers the potential for higher rewards, it also comes with increased risks, higher costs due to transaction fees and management expenses and the challenge of consistently beating the market over time.

Skilled investors or fund managers often employ strategies such as growth investing, value investing, or momentum trading to capitalize on short-term opportunities, making active investing a more hands-on and research-intensive approach to wealth generation.

Consider an investor who buys stock in a company like Walmart. After the investor thinks he or she has identified a pattern in the company’s stock, the person will buy and sell shares under the stock’s predicted performance. Therefore, the person’s goal is to identify and exploit market trends. This approach could work, depending on the strategies you employ. However, it also presents a few advantages and disadvantages.

Pros and Cons of Active Investing

Those considering active investing should weigh the pros and cons of this approach. One advantage is that you’ll be able to tailor your portfolio to meet the market’s current conditions. This not only minimizes risk but also allows for profitable trades. Another pro is that hands-on investing creates opportunities for potentially successful short-term wealth growth.

For instance, if a particular stock has momentum, investors can alter their trades accordingly. Finally, active investors will also have a lot of flexibility when choosing which investments and stocks to purchase or sell. The process typically requires thorough research, but it can be great for those looking to make cultivated investment moves.

This style of investing, however, also presents some disadvantages. One is that active investing can be expensive due to the excessive number of trades. You can run into trading fees and investment minimums depending on where you invest. For instance, if you choose to invest actively with the help of a portfolio manager, you’ll typically encounter management fees. You’ll want to make sure that you don’t spend more on transactions than you earn through investing.

If your stock predictions are wrong, you’ll potentially lose a lot of money. You’ll also want to consider that active investing is research-intensive. Therefore, your return also depends on how well you follow news and developments about the companies you invest in. If you’re not updated with what’s going on with your company, you may not be as equipped to beat the market.

Passive Investing

Passive investing follows a more hands-off approach. It limits short-term buying and selling to establish long-term and greater financial returns. Instead of constantly altering your portfolio to meet the market’s conditions, you buy and hold with the goal of gradual wealth growth. Beating the market and exploiting price fluctuations isn’t the goal. Rather, passive investors typically aim to earn money through portfolio diversification and low-cost trading.

For instance, consider an investor who purchases a selection of exchange-traded funds or index funds to include in his or her portfolio. Because gradual growth is the goal, he or she will hold onto the investments rather than trading to outperform the market. A common passive investing strategy is to invest in index funds.

An index fund tracks an entire market index, and a market index includes a range of particular companies. The fund then buys every security included in the index. When investors choose index funds, this allows them to reduce risk because the fund purchases the securities, while they can buy shares from the fund.

The fund doesn’t try to outperform the market, it instead aims to replicate the gains and losses of the index being tracked. This creates greater portfolio diversification, depending on the index you choose to invest in. Some common indexes are the S&P 500 and The Dow Jones Industrial Average.

Pros and Cons of Passive Investing

Passive investing, though perhaps safer than active investing, does present some advantages and disadvantages. One advantage is that investors minimize additional costs since they aren’t constantly buying and selling stock. This limits the additional fees that come with excessive transactions. The passive strategy is also more tax-efficient. This is largely because buying and holding results in lower capital gains tax. Therefore, passive investors won’t have to pay as much in investment-related taxes.

You should also consider the downsides of this approach. When you passively invest, you lock yourself into whatever index fund or investment you select. So when the market changes and stock prices fluctuate, you can’t actively alter your investments. You’ll be locked into your assets without the power to capitalize on the market. In addition, passive investing won’t protect your funds from downward market slides. So while you’ll have a greater shot at gradual growth, there’s still a certain level of risk.

Investing Overview

Investing is one of the best ways to grow your money. Whether you’re in it for short-term financial gain or retirement-targeted savings, it can transform your financial situation. But it’s also important to note the several different types of investments before you choose how to invest. This mainly includes stocks, bonds, mutual funds and exchange-traded funds (ETFs), among others.

Stocks allow investors to purchase shares of publicly traded companies. Bonds, however, are debt obligations of governments, corporations or organizations. After you purchase a share of that obligation, the entity has to periodically repay you with interest.

Through mutual funds and ETFs, you pool your money together with other investors to purchase a collection of investments. While investment managers oversee both, there’s a notable difference between the two. ETFs trade on stock exchanges, but mutual funds don’t. Below we assess the differences between active and passive investing.

Which Should You Choose?

The approach you choose ultimately depends on your risk tolerance and financial goals. If you prefer short-term and cultivated wealth growth, you should consider active investing. Because of excessive trading and management fees, it’s also great if you don’t mind paying more for a potentially greater return.

However, if a hands-off, long-term approach makes more sense with your savings goals, passive investing could be right for you. This style is also good for those looking for low-cost, tax-efficient investing. However, each style presents advantages and disadvantages, so you’ll want to weigh those of each before making a final decision.

It’s also important to remember that no stock or investment comes without risk. Whether you actively or passively invest, you should prepare for a certain level of risk. Even blue-chip stocks are affected by stock market fluctuations. While the market’s volatility can’t be controlled, your approach to investing can. Therefore, the style you choose should reflect both your savings goals and your risk tolerance.

Bottom Line

Active and passive investing strategies offer distinct approaches to wealth building, each with its own advantages and drawbacks. Active investing appeals to those seeking to outperform the market through research, analysis and frequent trading, but it comes with higher risks, costs and the challenge of consistently beating market returns. On the other hand, passive investing provides a lower-cost, lower-maintenance strategy that aims to mirror market performance through index funds and ETFs, making it an attractive option for long-term investors.

Tips for Selecting Investments

• If you’re looking to either create an investment portfolio or improve the one you currently have, a financial advisor could be right for you. Financial advisors can help you with everything from investing strategies to portfolio diversification. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• It can be difficult to determine which investment type works best with your financial goals. Saving money is challenging, but deciding how to allocate your assets can be even harder. SmartAsset’s asset allocation calculator can help you structure your portfolio in a way that aligns with your risk tolerance and investment goals.

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