And what's the difference?
Active portfolio management is an attempt to beat a market index (e.g., the S&P 500 Index). It entails making active decisions, like “should I own stocks or bonds right now” or “should I buy more technology stocks this year” or “should I sell XYZ stock before its next earnings announcement”.
The key benefits of active management are the possibility of outperforming the market and the option to turn defensive in the hopes of avoiding bad market environments.
Passive portfolio management is an attempt to simply mimic a market index and minimize costs along the way. There are virtually no decisions to make in passive management once an index is selected.
The key benefit of passive management is reducing the risk of materially underperforming the market which may reduce the odds of achieving your investment objectives.
Neither strategy is inherently better than the other. What matters is which is most appropriate for you in attaining your long-term investment objectives.
To learn how to better determine which investing approach is most appropriate for you, click here.
For self-directed investors, the critical questions becomes, “Do I possess better portfolio management skills than the average of all market participants, and by a big enough margin to overcome the transaction costs I will incur by making trading decisions?” If the answer is “yes”, then active self-directed management may make sense.
If the answer is “no”, then another question must be answered, “Can I hire a manager that possesses better portfolio management skills than the average of all market participants?” If the answer is “yes”, then active management delegated to a professional may make sense.
If the answer is “no”, then another question must be answered, “Will I abandon my investment strategy during adverse times?” If the answer is “yes” or even “I'm not sure” then a professional who can provide regular counseling to keep you on the path to investment success may make sense.
If you answer “no” to all three of these questions, then passive portfolio management is probably the right choice for you.
However, keep in mind that while passive management may sound easy, it can be very difficult to stick with the strategy during bad markets or heightened volatility.
You may be tempted to sway from your strategy and “wait out” the so-called bad times. Doing so can mean missing a big up move and seriously impact your long-term performance. Or, you may become disenchanted with merely matching the market during up-market periods. Many investors, even passive investors, find they need guidance to help keep them disciplined through good times and bad.
Whether you are looking merely for guidance or for more complete portfolio management, hiring the right manager is critical. But what should you look for in a money manager? This guide can help you more deeply understand how the person you are considering hiring approaches markets and investing.
To learn more about selecting an appropriate investment strategy for your long-term goals, click here.
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