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Active or passive investing: Which is right for you?

LINDSEY BELL • May 27, 2022 • 5 min read

Scared, excited, nervous.

As stocks and the overall market whipsaw daily, so have our emotions.

The S&P 500 has been near bear-market territory (a decline of 20% or more) for weeks and some stocks have fallen a lot more than that.

Nowadays, the confidence that was quickly gained by many investors buying stocks with excess savings during the pandemic is eroding. Impressive gains have dwindled, and many are left wondering if buying stocks is worth the risk.

It’s been painful to be invested in individual stocks. It’s also been painful to be invested in broad market indices, which are more diversified by nature. Could investing in one be better than the other?

Performance removes emotion

Whether you invest in single stocks, an index, or a mix of both can be a personal decision. It often comes down to the level of comfort and experience a person has with investing. One’s personality can even play a role. Ultimately, your goals, timeline, and risk tolerance are what should drive your investing decisions. Not emotion.

Let’s take the emotion out of the question above. Let’s look at historical performance of active investing, or investing in individual securities (like stocks), versus passive investing, like investing in an index (or ETF that tracks an index).

The evidence is clear that actively managed equity funds have consistently underperformed the S&P 1500. In 2021, more than 79% of active funds underperformed the index. That was the third worst performance in 21 years. What’s worse is that 85% of large cap funds underperformed the S&P 500. This shows even professionals, who are armed with tons of information and do a lot of research on each investment, have a hard time picking individual stocks.

That said, it doesn’t mean active investing can’t work for you. More on that below.

Graph titled Professional, Active Fund Managers Miss the Mark shows Percentage of All Domestic Equity Funds Underperforming the S&P Composite 1500 on an Absolute Basis

Sentiment and the reacquaintance of passive investing

Lately it’s been hard to stay on course when it comes to investing- rebounds in stocks are often quickly sold. It’s no wonder investor sentiment has been so bearish. Since the start of the year, pessimism has weighed heavily on the minds of retail investors. So much so that we’ve seen a shift in the types of investments they have been making. Starting in January, Ally Invest customers sharply increased the mix of their investments to ETFs at the expense of other equities, including individual stocks.

While this type of activity often occurs in periods of market uncertainty, the steady monthly trend feels like a reacquaintance of passive investing. The appeal of a passive investing strategy has always been its ease and the benefit of diversification. ETFs or mutual funds do the heavy lifting of diversification by investing in multiple securities at one time. It’s often called the hands-off approach to investing because the investor benefits by not having to do this work on their own. It works well for those that have a long-term outlook as you are less likely to monitor the daily movements of the market.

Passive investing has never been overly exciting, and that’s the point. That can help you stay invested during periods of significant volatility.

Active investing anxiety

The excitement of stock picking and the active investing strategies approach reached new levels of popularity during the meme stock trading phenomenon in early 2021. Now, stock market losses have made some investors sour on the strategy.

Investing in individual stocks requires a lot of homework to make smart investing decisions. It is a very hands-on style of investing which often includes frequent trading of securities. When stocks are declining, a bear market is near and volatility is high, second-guessing investments is normal. It can also lead to heightened trading activity which has historically hurt the performance of a stock portfolio.

Keeping your wits about you can be tough on you and your portfolio.

Pro-active investing

Investing in stocks can be fun. The most important job when investing, whether it is with one stock or 15, is risk management.

In a volatile environment, a proactive approach will help you keep your cool.

Active investing takes a short-term view, by its nature. This allows the investor to pivot quickly when the environment or strategy of the company whose stock they own changes. That said, the smart active investor knows the level of risk related to each stock they own and has a  plan for when to sell, when to buy and when to hold the course.

Often times, the best action an active trader can take is to do nothing at all. As hard as that can be when you see your brokerage account value swing so much week by week, making emotional trades don’t usually work in your favor.

Active investors should not be reactive.

The bottom line

People hate losing more than they like winning, as psychologists Amos Tversky and Daniel Kahneman proved in 1979. A volatile market can cause even the savviest investors to make trades they will regret later as they try to cut losses. Active, or short-term traders, should have a plan in place for times like these. For those with a longer time horizon, a hands-off passive investing approach might work better. Neither is a one size fits all strategy. A mix of both can help satisfy a need for the excitement and the need for long-term stability. Just make sure you aren’t taking on more risk than you can handle.

Lindsey Bell is an award-winning investment professional with a passion for personal finance and more than 17 years of Wall Street experience. Bell’s unique ability to connect the dots between data and real life and craft bite-sized money ideas that people can use and apply stems from her deep background as an analyst, researcher and portfolio manager at organizations including J.P. Morgan and Deutsche Bank. She is known for demonstrating why and how an understanding of all things money improves a person’s finances and overall well-being. An ongoing CNBC contributor, Bell empowers consumers and investors across all walks of life and frequently shares her insights with the Wall Street Journal, Barron’s, Kiplinger’s, Forbes and Business Insider. She also serves on the board of Better Investing, a non-profit focused on investment education.

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