When the economy is uncertain, like in 2020, people tend to get nervous. And that often means they want to make changes to their investments. But that may not be the best strategy. In fact, I recently talked to Daniel Crosby, a psychologist who specializes in money, about this very question. He said, “The history of panic suggests that panicking doesn’t do any good.”
According to the research he studied, people who changed their investment portfolios in a panic had to make correct calls more than 80 percent of the time for their portfolio to perform as well as if they had just done nothing.
You can listen to more about that research on the Minority Money podcast, but I want to use it as an introduction to talking about active versus passive investing.
Active investing refers to what we might classically think of as investing: picking investments you think will perform well. Active investors often try to time the market, usually by trying to buy low and sell high.
Active investing is what Crosby was talking about when he said people might, when they’re worried about the market, go in and tinker with their investments to try and protect their money.
Passive investing involves buying an investment and holding it for a long period of time. You’re sitting back (passively) and not trying to buy or sell at a particular time or price. This is what Crosby described in his example as simply doing nothing.
The concept of passive investing has expanded in the last few decades, and nowadays, it generally refers to how you approach investing as a whole.
Passive investors generally buy funds that track an index, like the S&P 500. These are known as index funds. Investing in an S&P 500 index fund is about as close as you can get to investing in the broader stock market, which has historically returned between 7-10 percent per year on average. You can also invest in funds that track the Dow Jones Industrial Average, the Nasdaq or even international indices.
Which investment strategy is right for you depends on a wide variety of factors.
If you’re investing for yourself
If you’re buying and selling your own investments, there are a few things to think about:
- Are you prepared to do the research required to pick the right investments for you? And do you have a plan to buy and sell based on numbers, not emotion? (This question is particularly important in a high-stress situation, like a recession or when markets are volatile.)
- Do you understand the fees involved? Individual trading often comes with fees (and sometimes commissions) that can eat into any potential returns. If your brokerage charged a fee of $1 per trade, for instance, your investment would need to increase in value by more than $2 for you to realize any actual gains (since you’d pay $1 to buy and $1 to sell).
- Do you understand the logistical aspects of trading? To invest actively, it’s important to understand order types, market volatility and other factors that can influence your overall success.
If you’ve answered no to any of those questions, you may not want to invest actively, or at least not with large sums of money and a goal of making a profit. As an alternative, you can ask an advisor or other investment professional to actively manage your investments for you. Advisors are trained to research investments and can be more strategic and less reactionary with active investing decisions.
There’s one final layer of active versus investing that we should talk about. Active and passive aren’t just terms that apply to how you invest. The funds you invest in can be actively or passively managed, too.
Fees and funds
When you invest in a mutual fund or ETF, the person who runs the fund charges a management fee. This fee compensates them for buying and selling assets within the fund and keeping everything straight.
For active funds, this fee is generally higher, since the manager is strategizing about which stocks to pick and when to buy or sell them. Make sure you evaluate these fees when you look at a fund’s historical returns.
On the other hand, passive funds are increasingly managed by algorithms. Experts program computers to buy, sell and rebalance in a way that mirrors the index it tracks. These types of passively managed funds tend to have the lowest fees, since there’s less manpower required to run them.
Which should you choose?
Often, this is a personal question that depends on the factors we just discussed. And there are entire books written about which approach is better.
Whichever you choose, remember this guidance from Daniel Crosby: The rules of good investing are inverted from the rules of everyday life.
The best way to manage your investments is often to do less. Even if you’re actively investing, you may perform better if you take emotion out of it and follow a plan. This is opposite from everything else we do in life, where better results require you to do more. So it can take some getting used to. While fighting these instincts can be hard, it’s one reason you have an advisor like me on your side to help you talk through any decisions and make sure your investing plan makes the most sense for you.