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Understanding the difference between passive and active investment

Category: News

You’ve likely heard the terms “passive” and “active” investments from us before, but you might be less sure about the difference between them.

Both have their pros and cons and, as with all the financial decisions you make, there is no one-size-fits-all approach. It’s also true that you don’t have to make a binary choice. Diversification is vital to any successful portfolio so you might want to consider elements of passive and active investing.

But what is the difference between the two? And what do the differences mean for how you approach your investing journey?

Keep reading to find out.

Passive investments look to deliver returns in line with a market index or a selection of markets

Passive investment typically involves tracking a single index, like the FTSE All-Share. (It can, though, track a selection of markets.)

As the name suggests, passive investment is less “hands-on” than active investment. It requires patience, a focus on your long-term goals, and occasionally, a certain degree of nerve.

You’ll need to block out the noise of short-term market volatility and believe in your long-term strategy.

The approach is often lower risk, less expensive, and based on the belief that markets are intrinsically efficient.

Low risk

By getting to know you, your risk profile and your aspirations, we can put a portfolio in place that meets your goals within your desired time frame.

We’ll diversify your portfolio to spread risk. We’ll also review it regularly in case your attitudes and priorities change, or if external events mean we need to reallocate assets.

Lower costs

The “buy and hold” approach of passive investing means you’ll buy shares to keep them over the long term.

As US billionaire Warren Buffett famously said, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes”.

This approach means they’ll be little trading with passive investment. In turn, this leads to lower transaction costs and management fees.

Efficient markets

Passive investment relies on the belief that markets are efficient and also “fair”.

Markets are constantly shifting in response to myriad factors, from global events to local politics – in fact, anything that affects consumer confidence and increases or decreases certainty.

The Efficient Market Hypothesis (EMH) believes that while asset prices will fluctuate, they will always trade at a price that is fair and based on up-to-date information.

Active investing involves making regular decisions in an attempt to outperform market indices

Active investing involves analysing markets in a bid to outperform the indices tracked by a passive approach. This has the potential for better returns.

It’s a more “hands-on” strategy that requires deep analysis of the markets and a high level of expertise. That usually means higher fees and greater risk, along with a divergent view of the efficacy of markets.

But the chance of greater rewards – and a direct focus on your goals – means that the higher risk and costs could prove worthwhile in the long term.

Increased risk for higher rewards

With an active investment, fund managers are constantly on the lookout for the next rising share.

This means timing the market to take advance of short-term opportunities, which increases risk. But the increased risk comes with the potential for greater returns.

Higher costs

Active management requires constant analysis of markets and many more trades (each of which incurs costs). For this reason, active investing can prove more expensive. The potential for increased returns, though, means this could be a price well worth paying.

As with any aspect of your financial plan, the right approach for you will depend on your personal circumstances

Inefficient markets

In direct contrast to passive investment’s belief in the EMH, active investment looks to exploit inefficiencies in the market and make the most of mispriced shares.

Get in touch

There are many different factors to consider when building an investment strategy, including your risk profile, capacity for loss, and timescales. These inform the makeup of your portfolio from the asset allocation to the regions, sectors, and asset classes you invest in.

Active and passive investments both have pros and cons and like the rest of your financial plan, a one-size-fits-all approach is unlikely to the be right answer. That’s why we build a financial plan and an investment strategy that is as individual to you as your fingerprint is.

If you have any questions about what you’ve read or you’d like to discuss your investment strategy in greater detail, speak to us now. Get in touch by emailing or calling 03452 100 100.

Please note

The value of investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

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