In this article we

• define passive and active investing
• discuss the pro’s and con’s of passive and active investing

There are roughly 2 types of investors, passive and active.  If you are someone who wants to minimize risks, isn’t as easily influenced by what everyone else is doing, and is more interested in a company’s historical information than the day to day stock prices, and has the patience to see in slow, steady, long-term growth, you are likely a passive trader. 

Then there are those who like to be more hands-on, are ok with a little (or sometimes a lot) of risk, tend to follow market trends, and hope to make it “big” overnight.  They often buy and sell stocks on a regular basis and will sometimes make trades based on a hunch or a ‘gut’ feeling.  This is considered an active trader.

Calling someone who trades actively in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic.” 

Warren Buffett, The Essays of Warren Buffett;  Lessons for Corporate America

Those are some pretty harsh words from Warren Buffett, arguably one of the most successful investors of our time, and a huge advocate of Value Investing (DYF Investing’s philosophy), which falls in the passive investor category.  Why does he feel this way about active trading?  Let’s look at the pros and cons of both to understand a bit more.

Active Investing

Some of the Pro’s include;

• Flexibility – unlike mutual funds (one of the most popular forms of passive investing) that bundle stocks in an all-or-nothing fashion, active trading often involves purchasing various quantities of individual stocks – any stocks you want.

• Possibility for high returns – Active traders tend to buy and sell very quickly, sometimes multiple times in the same day.  The idea is to watch prices that trend down, then attempt to predict which ones will rebound.  Buy low, sell high and make a quick profit.  But since no one can truly predict what a stock will do, this often is a lot like gambling in that most of the time you merely hope you chose well and the odds are in your favor. 

• Can easily buy or sell based on market trends – As an active trader, you are likely to own multiple individual stocks, making it easy to buy or sell just one or as many as you like, allowing you to easily follow market trends.  This is much harder to do with a mutual fund that does not give you the option to pick and choose individual companies.

• Diversification – Again, because you are not buying into an index or mutual fund, you can target an industry very specifically, purchasing several companies within just one industry, or you can spread out over as many industries and sectors as you wish. 

Some of the Con’s include;

• Higher fees for numerous transactions – Each trade costs money.  If you are making several trades per day or week, these fees can add up very quickly and eat into your profits (or only add insult to your losses). 

• Requires higher level of market analysis and regular management – In the pro’s section we mentioned the possibility for higher returns, noting that some traders will buy and sell in the same day.  We feel these trades should never be made based on a hunch. The most experienced market analysts will spend a great deal of time researching and analyzing companies.  Sometime for weeks or even months, deciding on which stocks to buy and when.  They pay close attention to the stocks on their ‘watch list’ and even closer attention to the stocks they own, looking for just the right moment to buy or sell.  Doing this well requires a great deal of time and attention, and even in the best of scenario’s, the experts still do not beat the market the majority of the time. 

• Higher risk – Active trading, or day trading as some refer to it, is highly risky. As mentioned above, such a big part of the active trading philosophy is predicting when stock prices will rise, fall, and rise again.  The problem is almost no one is able to do this with any sort of consistency.  Just like gambling, losses are experienced far more often than not.  But for some, the thrill of the payout is very enticing, and what makes this sort of trading so appealing.  This type of thrill seeking is totally fine for smaller dollar trades and money you can afford to lose, but would you really want to gamble with your entire retirement fund?

Which is why Warren Buffett is so opposed to the active trading philosophy because your odds of losing money are so much higher than the odds of making money. 

Whereas active traders hope to predict the trends and beat market averages, passive investors simply want to duplicate it.  It’s a little like the tortoise and the hare.  Active investors want to make a quick profit, but passive investors believe that slow and steady diligence through market ups and down will in the end yield them consistent, respectable returns.

Passive Investing

Some Pro’s include;

• Lower costs – Fewer trades mean fewer fees.  Something to note is that many mutual funds, very popular within the passive trading world, actually charge a great deal in hidden and hard to find management fees.  Despite this, active trading still tends to be more costly over time. (For the record, even though mutual funds are quite popular, DYF Investing is not a fan of mutual funds, hence the name Ditch Your Fund Investing.)

• Lower risk – The passive trading philosophy teaches investors to buy stocks then hold on to them for an extended period of time, decades in some instances.  The idea is that if you have chosen some really solid companies they will continue to grow and be profitable well into the future, despite any situational or short-term drops in price. Mutual funds (which again, we don’t actually recommend) generate a layer of safety by including a variety of companies across many sectors and industries.  The idea is that if you have 100 companies, and 10 of them do very poorly, but 10 of them do well and the other 80 simply maintain, things have evened out, and you reduce the risk of losing money. Additionally, many index funds include only the top performing companies.  If a company becomes too volatile or drops out of the top 500 for example, it might also be dropped from the index, making it a very safe place to put your money. 

• Higher average returns – Here again the tortoise and hare analogy tends to hold true.  On average, index’s like the S&P 500 have steadily and consistently generated an average rate of return of about 11% over the last 100 years.  While many mutual funds and most active trading experts cannot come close to this number, there are other index’s like the Vanguard 500 Admiral, for example, that boasts just over 11% returns over the last 10 years.

Some Con’s include

• ‘boring’ – You will not find a Vegas-like thrill as a passive investor.  But you will significantly increase your odds of having enough money to find other thrilling and exciting ways to pass your time, come retirement.

• Miss out on some potential good buys –  If your money is tied up in funds or indexes, or you are trading based on the principles of Value Investing, you might miss out on some great opportunities that fly under the radar.  But keep in mind that some of these opportunities are also where the speculation and risk comes in.  If you are willing to live with a few possible missed opportunities in lieu of creating consistency and stability, passive/value investing might be right for you.

• Greater length of time needed to see larger returns – There is no doubt active trading has the potential to “hit it big” quickly. That’s the enticement of gambling and why millions of dollars are lost each year at casino’s around the world.  Passive investing is not going to make you rich over-night, but the sooner you start investing, or the longer you can allow your investments to grow, the better your odds at generating wealth.

At DYF Investing we are clearly biased toward passive, Value investing.  Primarily because we LIKE the idea of generating wealth, not gambling.  We do recognize though, that there are a few enticing advantages of active trading, the gambling part aside. 

As part of our mission to empower investors with the best investing tools available, we feel we provide a bridge, taking the best of both the active and passive worlds. Utilizing strategies that seek out the low-cost, safe, and consistent growth of passive (value) investing, we also hope to teach sound strategies that take advantage of the flexibility and diversity of active investing. 

Warren Buffett’s first rule of investing is “never lose money.”  But he also says “risk comes from not knowing what you are doing.”  At DYF Investing we want to educate you on value investing, putting all the control in your own hands.  We also want to mitigate as much risk as possible and aim for companies that have the best potential for higher returns over time. 

In our perfect world, you are “actively” managing your investments based on logic, solid information, and historical data, not market trends or emotion.  You are buying and selling when it makes sense, based on intelligent analysis.  Armed with this information you might choose to buy and sell in a relatively short period of time, but you are also comfortable holding investments for as long as is needed to reap the rewards of your investing strategy. 

Passive and Active investing consist of 2 very different mindsets.  Regardless of the philosophy you ascribe to, we encourage you to do your homework and educate yourself.  Whether you get that information from us or someone else we want you to make intelligent decisions that not only make sense for you, but make you money as well.