Key Differences Between Active and Passive Investments
You may have heard experts investors advising newcomers to invest in assets that generate passive income, especially if they are making investments for their future. Also, most financial advisors suggest their clients choose their active and passive investments very wisely to increase the security of their portfolios and generate more profits. But what exactly are active and passive investments? What are the differences between active and passive investments? What are the advantages of active investments over passive investments or the other way around? We have answered all these questions here.
What are Active Investments?
Active investments involve close monitoring of the asset value by a portfolio manager. It allows the investors to escape the average return feature of assets and take on the short-term price changes instead. This helps the investors in getting maximum profits on their investments rather than obtaining average portfolio returns like other investors at the end of the year. The concept of active investments may look very attractive to investors looking for instant gains. It involves a very deep understanding and analysis of the asset and its price history over an extended period of time.
The portfolio manager and their team of analysts closely monitor and analyze the qualitative and quantitative performance of the asset over a long period of time. After careful analysis of the asset’s performance, they predict the dips and peaks in the price change of the asset in the future. It’s not possible to exactly predict the time to buy and sell the asset and be right at all times. So, active investments are about making the right predictions more frequently than making wrong ones. Mutual funds are examples of active investments.
Advantages of Active Investments
- Flexible, the investors can buy the assets that look profitable to them without having to follow a specific index.
- Hedging, the investors can buy and sell their assets whenever the market seems to go down.
- Tax management, if the investor suffer losses in their active investments, the tax management strategies may be applicable to offset the capital gains on other investments.
Disadvantages of Active Investments
- Expensive, the average expense ratio is 1.4 for active investments.
- High risks, the investors are free to choose the asset offering the highest returns.
What are Passive Investments?
The main idea of passive investments is to invest in assets for a long period of time, instead of looking for instant gains. Passive investments refer to the investments whose buying and selling are limited by the investor. This helps to increase the cost-effectiveness of the investments. In contrast to the buy and sell strategy used in active investments, passive investments involve a buy and hold mentality. This means that the investor should hold the asset rather than get lured by the increasing price of the asset and sell it off.
Index funds are the most common examples of passive investments where the asset holdings change whenever there is a change in the index fund. This means that when an asset leaves the index, it is sold off. Simultaneously, the one entering the fund gets bought automatically. This is why companies work hard to appear in major indices like S&P 500. It is because it promises the fund to be included in the major holdings. ETFs, gold, and silver investments are examples of passive investments.
Advantages of Passive Investments
- Low investment fee, since investors barely pick these investment assets.
- Transparent, the assets in the index fund are visible to all.
- Tax-effective, they do not generate any such great capital gains over a year that have may have tax implications.
Disadvantages of Passive Investments
Some of the disadvantages of passive investments include:
- Very Limited, the investors may be locked in these assets irrespective of the changes in the market.
- Small returns, unless the market grows dramatically.
Difference Between Active and Passive Investments
Here are some of the key differences between active investments and passive investments. This is to help you understand how to diversify your portfolio among active and passive investments to get maximum returns and security.
- The active investments aim at conquering the market index. In contrast, the aim of passive investments is to generate high returns to the holder.
- Active investments involve buying and selling assets and getting hands-on experience in dealing with the assets. On the other hand, passive investments mostly include researching, buying and then holding the asset for a long time to generate profits.
- The costs of research and transactions in case of passive investments is lower as compared to the costs of active investments.
- Active investments are subject to higher taxation on capital gains as compared to those of passive investments.
- Passive investments may look like a better option for investments as they involve lower risks. But the risks may be higher in case of active investments against higher profits.
While choosing between active and passive investments to make your investment decisions, the investors should consider their investment goals. The investors looking for short-term capital gains should go for active investments as they perfectly fit in their investment plan. On the other hand, the investors looking for long-term capital gains must go for passive investments. In addition to this, 90% of passive investments have outperformed their active counterparts. Also, passive investments have proved to offer higher returns as compared to active investments. The risks involved in passive investments are much lower than active investments. But if you are looking for higher returns and do not care about the risks, then active investments are good to go for you.