(This article was first published on Making Smalltalk.)
Remember that fable about the tortoise and the hare? Of course, you do. All of us have read this story when we were in school and learned the famous moral that came with it—Slow and steady wins the race. Who can forget that classic, right? Let’s look at how that story can be an analogy to understand active and passive investing.
Well, let’s explore it with a few twists and turns. The tortoise and the hare, once again, set out on a race. Both of them have the goal to reach the finish line. There is a main road from the starting point to the finish line, and the tortoise sets out on it. The hare, though, is not satisfied with taking the obvious route. It wants to improvise to try to reach the finish line quicker.
The hare sets out on the main road but keeps looking for other connecting roads that could lead to the finish line. It explores shortcuts and different routes. While the hare does all of this, the tortoise is simply walking on the main road towards the finish line.
Here, unlike the original fable, both the tortoise and the hare do reach the finish line. Both of them are winners, but what’s different is how they win. This is also the difference between passive investing and active investing.
In our story here, the tortoise is the passive investor while the hare is the active investor.
What is passive investing
Passive investing is the type of investing where you follow a fixed path. In investment jargon, this is called following a fixed strategy that involves minimal involvement. Investing in an index fund or an ETF that tracks an underlying index is an example of passive investing. This underlying index could be the Nifty or Sensex or any other benchmark index.
Another example of passive investing would be investing in a fixed strategy that requires just some minimal and pre-determined involvement, like a quarterly or annual rebalance.
In our story, the main road taken by the tortoise would be the underlying index that it is following. The tortoise knows that this road will take him to the finish line and all it wants to do is follow that road without bothering about anything else. In the same way, a passive investor would invest to follow a specific index and not bother about the rest of the markets.
What is active investing
On the other hand, an active investor, much like the hare, would want to follow a more active strategy to fulfil his or her goals. An active investor wouldn’t simply follow an index. He or she would look for investments in other segments of the markets. The way the hare explored different shortcuts, an active investor would invest in riskier assets in lieu of earning higher returns in a shorter period of time.
Difference between active and passive
Hence, the main difference between active investing and passive investing is that the former requires consistent involvement while the latter involves limited change.
While both active and passive investing can be for the long-term, passive investing works better over longer periods. With active investing, there are always a lot of activities around the market movements. This also leads to higher churning, which makes active investing more expensive than passive investing.
Another reason for active investing being expensive is that actively-managed equity funds have a larger fund management team made up of researchers and analysts. Their job is to look for investment opportunities that can generate higher returns, which is why actively-managed funds have a higher expense ratio as compared to passively-managed funds like ETFs or index funds.
Active investors usually act as portfolio managers. They have a hands-on approach and are continuously on the lookout for investment opportunities. This is also why active investing requires a large amount of time, expertise and knowledge.
Active investing can be riskier
The idea behind active investing is to beat the markets or generate above-average returns. This is what the hare in our story wanted to do. It was looking to use different routes so as to reach the finish line faster. The tortoise was happy to reach the finish line in a reasonable amount of time using the main route.
While active investing can beat the markets, it tends to be a riskier strategy where the investor can end up with substantial losses. The hare, after all, could have gotten lost using one of the inside roads and might have never reached the finish line in the end.
Hence, it’s up to you as an investor to decide if the risks associated with active investing are worth it for you or not. There’s a case for both types of investing. What you choose to go with would depend on your investment goals and risk profile.
But if you don’t want to worry about market movements and just want to build wealth passively over the long-term, then investments like Smart Beta smallcases would be ideal for you.