Very broadly speaking, there are two basic approaches to investing: active and passive. So what’s the difference?
What it’s not
Some people might (incorrectly) suggest that an active investor is someone who makes frequent trades (up to multiple times a day), while a passive investor is someone who makes infrequent trades (once a month or less). But frequency of trades really isn’t the best way to understand active vs passive investing.
Others might (also incorrectly) suggest that an active investor is someone who handpicks their stocks based on market conditions every time they buy, while a passive investor is someone who buys the same securities repeatedly. This, also, isn’t the best way way to understand active vs passive investing.
What it is
In simple terms, an active investor is someone who is trying to beat the market, while a passive investor is someone who is trying to replicate the market (or a market segment). The movement of a market is measured by weighing all the individual stocks in that market and averaging out their direction. So when you hear that the TSX is down 2%, it means that while some of the stocks may have gone up and others gone down, overall, the average stock price fell 2%.
As of writing this post, the TSX is up 4.61% compared to a year ago. A passive investor looks at that number and says “yeah, I could settle for that.” An active investor says “nah, I could do better.”
How it works
Again, the key to all of this is that a stock market’s average return is literally just the combined return of all the stocks on that market. This means that if you bought a portfolio 1 year ago of all the stocks on the TSX, weighted by their market share, your return over the past year would be 4.61%. It’s really just junior high level math.
So, a passive investor chooses to guarantee themselves a return equal to the average market return. An active investor attempts to predict which stocks will outperform the market average. If the average return of their portfolio is higher than the average return of the market - boom, they won.
This is why the first two definitions of active vs passive investing are faulty. An active investor could buy $10,000 worth of a few stocks and hold for a year, in the hopes that they outperform the market, while a passive investor could buy $20 worth of the market every day for a year. Frequency doesn’t matter.
Similarly, an active investor might keep buying Tesla over and over, while a passive investor will continually rebalance their portfolio to align with the market.
So which is better?
The answer is a little bit complicated (but only a little bit). If you want to get rich quick, passive investing ain’t gonna do it for you. But for my money, I’d choose passive investing over active investing any day. And that’s because it turns out humans are awful at predicting what stocks will over-perform. In fact, over the past 20 years, about 90-95% of active investors failed to beat the market.
The situation gets even worse when you consider that a lot of active investors are actually paying someone else a management fee to pick stocks for them, which takes even more off the top. On the other hand, there are plenty of low-cost ETFs which attempt to replicate segments of the market, like the well-know-and-loved VGRO or XGRO. (portfolios like these are called “index funds”).
Of course, the real answer is that we should all just keep buying GameStop.