One of the enduring debates of the financial world has been the choice between active and passive investing. While one propagates acting on major movements in the market, the other functions on the patience of the investor and a long-term investment outlook. A passive investment strategy has ‘buy and hold’ at its core.
As the name suggests, passive investing entails a non-active role on part of the investor. When you invest in a diversified portfolio with low costs and a long-term horizon, it tends to deliver returns comparable to the market average. Passive investing works on the premise that the market delivers positive returns in the long term and hence the portfolio has to be held without substantial changes for a long tenure.
One can apply passive investment strategies in a variety of ways, but indexing is the simplest of the lot. Indexing means mirroring an index, which automatically diversifies the investment across sectors and companies. Indexing has its advantages and drawbacks. Passively investing thorough indexing is simple, transparent, tax-efficient and cost-effective.
Since indexing requires a long-term commitment and the deployment of the corpus is benchmarked to the index, the portfolio remains unchanged for the entire tenure of the investment. It reduces the cost of the investment as there is no buying and selling of securities. It is also transparent as the investor knows the composition of the underlying assets, which also makes monitoring easy. A passive investment strategy is relatively easier to implement as it doesn’t require portfolio modifications according to market movement.
While passive investing can be rewarding, it is not without flaws. One of the primary drawbacks is the limited scope of the investment. A passive investment portfolio remains limited to certain indexes or a limited type of assets, without any major changes. It invariably leads to the investor getting locked in the investment even during adverse market conditions. Passive funds also offer lower potential returns, especially when the investment horizon is not very long.
Active vs passive investment
To understand the difference in the performance of active investment and passive investment, one has to know the key differences. Active investments are substantially more flexible when compared to a passive portfolio. An active fund manager doesn’t have to follow an index and can modify the portfolio depending on his/her reading of the market. Passive funds stick to a limited number of assets, which eliminates the need to buy or sell frequently and thus reduces the cost of the fund. Active fund managers keep changing the assets under management, but a passive investment portfolio remains unchanged. Even though passive investments offer lower potential returns, it also has a lower risk. Active funds dabble in a variety of assets, which could be risky if the investment premise doesn’t work.
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