Depending on their financial goals and level of expertise, investors may choose a low-risk investment strategy to try to replicate the success of market benchmarks such as the S&P 500. This is called passive investing. More knowledgeable investors who have a higher risk tolerance may invest in a way that attempts to beat the benchmark using an active investment strategy. Working with a financial planning firm can help you determine which strategy aligns best with your financial goals and risk tolerance.
What is passive portfolio management?
Most beginners and people with a low-risk tolerance or a lack of time or tolerance to manage an investment portfolio choose passive portfolio management. This is a long-term investment strategy that aims to match investment growth in the market over the long term. It is frequently referred to as a buy-and-hold strategy.
Passive investors ignore the short-term fluctuations in the market, which means that their investments do not require frequent monitoring and responses to changes in the market. Passive investments grow over time, especially if investors continually add funds.
Passive investment portfolios are made up of the securities in a given market index. The proportions are the same as the index, and the goal is to match the index’s performance over time. Passively managed portfolios have a lower risk for investors than actively managed portfolios.
Passive investors invest in hundreds to thousands of different assets, including a range of stocks and bonds, usually by investing in index funds. For example, a passive investor could buy an S&P 500 index fund. The investor would get the same investment return as the index, minus the cost of the fund. In 2023, the S&P 500 did exceptionally well, gaining an impressive 26% after a poor showing in 2022.
Fees are lower for passive portfolio management because research, maintenance, and trading costs are lower than for active portfolio management. Passive portfolios can also perform better and yield higher average returns than active funds because they enable investors to accumulate wealth over the long term, but they don’t generate the financial windfalls that active investors can get when a single stock soars in value, and they don’t provide much flexibility if the market should go through a downturn.
What is active portfolio management?
Active portfolio managers choose each asset in the portfolio based on its worth and potential to increase in value. Active investors try to beat the market, outperform specific benchmarks such as the S&P 500, or try to get the same return as passive investors but at a lower risk. Passive investment tracks funds over an entire market and, therefore, is subject to total market risk.
People who can tolerate more risk and desire the potential for greater financial gain from their investment portfolio may hire an expert to manage their portfolio. Active fund managers research and monitor the market to determine when the best time is to buy or sell a particular asset. They may also use trading strategies, such as hedging with options or shorting stock, to increase investment gains or tax management strategies, such as tax-loss harvesting, to reduce capital gains taxes.
Using active investing strategies does not guarantee a capital gain. In 2023, 60% of large-cap funds, 50% of mid-cap funds, and 48% of small-cap funds underperformed the S&P 500, according to a SPIVA U.S. year-end report.
Active portfolio investors need to weigh the potential gains from short-term fluctuations in the market with the additional fees incurred in commissions to actively manage a portfolio.
Many investors use a combination of active and passive portfolio management strategies.
Working with a financial planner near you can ensure you make the best financial decisions for yourself and your loved ones. Whether you choose an active or passive portfolio management approach, you will still need to re-evaluate your investment choices over time, especially as you approach retirement age. Your tolerance for risk changes depending on your life circumstances, and you may need to change how much you invest in the market and the assets you choose to invest in to rebalance your portfolio and manage taxes.