Module 1, chapter 3: You don’t always have to be actively looking for investment ideas in the stock market – there are decent returns to be made by staying a passive investor. If you've just set foot in the investment world and are confused about which investing method to choose, this chapter is for you.
Active investment versus passive investment has been a topic of debate for decades. However, while comparing the two, it is very important to realise that both forms of investing have their pros and cons.
What is Passive Investing?
Exchanges create a number of indexes that represent the general performance of either the market as a whole or of certain segments of the market. Popular indexes such as the Nifty 50 and the Sensex in India or the Dow Jones Industrial Average in the US have a few qualities. They contain 20 to 50 of the country’s biggest companies, which account for a big chunk of the entire market. Besides, these indexes are well-diversified and are regularly rebalanced to remove chronically underperforming companies.
Typically, the largest companies have the largest weightage in an index. This means that should you not have the time, inclination or skills to decide which companies to invest in, you can invest in such indexes. Such investments, usually done through what is called an index fund, is called passive investing.
In sum, by virtue of investing in the index, you have effectively created a well-diversified portfolio that exposes you to the country’s most well-performing companies. It has been shown that investing in an index is a very good idea. For instance, the Sensex has historically given about 15 percent returns over the long term.
What is Active Investing?
While some investors invest in an index, which is like a fill-it-shut-it-forget-it approach, most investors decide they want to create a portfolio that is different from the index. In effect, they think that a customised portfolio created by using their own understanding of investing may result in returns that are better than that of an index. This is called active investing.
At a practical level, though, most investors choose the active investing route not only because of the lure of higher returns, but because the approach is more exciting and bestows a greater degree of control.
Investors who actively invest on their own need to have a much deeper expertise in areas such as reading financial statements or strong technical analysis skills to know when to enter or exit a particular stock.
Another popular method is to invest in an active mutual fund (the most popular type of mutual fund). In an active mutual fund, a professional fund manager who has the expertise in telling apart good stock investments from bad ones, pools money from a number of investors and creates an active portfolio. The fund company typically charges a small annual fee for this service to meet its costs and generate a profit for itself.
Active vs passive: What should you do?
Research over the past several decades suggests that while passive investing sounds like a boring concept, it is a very powerful investment method.
Behavioural finance, which studies the impact of human emotions on financial decision making, shows that most investors harm themselves by being overactive in the markets or because they fail to recognise the most important qualities needed to succeed in investing: patience and a sound temperament.
There’s also been another development. As the markets become more efficient, many investors, including seasoned mutual fund managers, find it increasingly difficult to generate returns that are better than those of the benchmark indexes, especially after accounting for costs and risks taken.
As a result, most investors would do well to invest in passive funds.
This is not to say that no one should go for active investing. Far from it. History has shown that experienced investors can generate returns that far exceed those of the indexes. But such investors form a small segment of the market. Having this knowledge will remind you that you need to have spent a fair amount of time learning the tricks of successful investing and trading.
Many investors confuse the ease of entering the markets – low capital requirement, the ability to invest in whichever company they wish to – with being successful in the market. Like all fields, expertise in successful investing and trading is built through years of efforts in building a knowledge base and time spent practising the art.
Finally, passive vs active investing need not be an either-or situation. In fact, you would do well to invest a significant portion of your equity portfolio in a passive fund, while investing the remainder in an active portfolio – either constructed on your own or by investing in an active mutual fund.
Active vs Passive Investing — Key Differences
The key differences between active and passive investing can be best explained by their pros and cons:
Active Investing ― Pros and Cons
- Flexibility — Active investors don’t need to follow a particular index. They can buy any stock they believe has the potential to rise in the market.
- Better returns – Active investors can generate returns greater than that of an index. This is also called ‘alpha’.
- Expensive — Active investing is generally costlier than passive investing. Why? Because all the frequent buying and selling incurs hefty transaction costs and you have to pay the salaries to the analysts researching and picking stocks for you. These factors can sometimes kill returns.
- Higher Risk — Active investors can buy any investment tools they think will bring high profits and returns, which is great provided that a team of skilled analysts is working for you. However, if they pick the wrong stocks, active investors may also have to suffer greater losses.
Passive Investing ― Pros and Cons
- Low fees — Passive funds, through which you can invest in an index, charge very low fees simply because the mutual fund company does not need to do any research to construct the portfolio. They simply have to copy the index.
- Transparency — Passive investing is more transparent than active investing. Since it involves index stocks, everything is very clear and simple.
- Limited — Passive funds are limited to a specific set of investments or indices with negligible variance. Therefore, investors are stuck with their holdings regardless of the market situation.- No chance of alpha — Passive investing can’t beat the index, meaning your chance of generating alpha is zero. On the other hand, active investors stand a chance to reap higher returns if they are successful.