Active vs Passive Investing: Key Differences Explained

Investing to grow your wealth is key to building a strong financial future. Whether you’re saving for retirement, a big life event or just want to grow your wealth, investing can help you be prepared.

There are different options to invest and build a nest egg. Active and passive investing both aim to maximize your returns in different ways. Understanding these two fundamental strategies can help you choose an investment approach that helps you reach your financial goals.

What is active vs. passive investing?

Active investing and passive investing are 2 different ways to manage your investment portfolio. Both strategies share a common goal: growing your wealth. However, they achieve that goal in different ways, with some unique pros and cons.

• Active investing is a hands-on approach to managing your investments. It requires frequent decision-making and monitoring your portfolio. Many active investors work closely with financial advisors. 
• Passive investing takes a more hands-off approach. It involves investing in funds or portfolios that mirror a specific market index or asset class. Passive investors focus on long-term market growth and aim to mirror its overall performance. They tend to stay the course and don’t make frequent changes to their investments.

What are active vs. passive funds?

In addition to active vs. passive investing styles, it’s also important to understand active vs. passive investment funds. Many investors put their money to work in the market in these types of funds. Here’s how they compare:

• Active funds are managed by professional investors who aim to beat the market. The managers use research and expertise to pick investments they believe will perform well. Many mutual funds and some exchange-traded funds (ETFs) are actively managed. Active funds usually have higher fees due to their hands-on management approach.
• Passive funds simply aim to mirror—not beat—the performance of a specific market index. These funds typically buy and hold securities in an index. Many ETFs and index funds are passively managed. Passive funds generally have lower fees because they require less active management.

The main differences between active and passive funds are in their management style, costs, performance goals and level of risk. Understanding these can help you choose funds that align with your investment strategy and financial goals.

Quick Comparison: Active Funds Vs. Passive Funds

Active Investing: Pros and Cons

Active investing appeals to people who want to proactively manage their investment portfolios. The goal is to outperform the market.

Active investing comes with some key advantages and drawbacks:

Key Considerations for Active Investing

Active investing offers the chance for great returns, but it also requires more hands-on management and comes with higher risks. 

A few questions to think about as you evaluate your options:

• What are your financial goals?
• What is your risk tolerance?
• How much time can you dedicate to managing investments?
• How much access do you have to expert information?

An active investing strategy can be suitable for investors who are willing to pay more for a shot at potential returns. They also have a higher tolerance for risk and prefer a more hands-on approach to building wealth.

Passive Investing: Pros and Cons

Passive investing appeals to people who want a more hands-off, predictable approach to managing their investments. The goal is to match market performance over time.

Passive investing comes with some key advantages and drawbacks:

Key Considerations for Passive Investing

While passive investing offers lower costs and simplicity, it also means accepting market-level performance and risks. 

A few questions to think about as you evaluate your options:

• Are you comfortable with a “set-it-and-forget-it” approach?
• Are you comfortable with returns that match the market?
• Do you have confidence in the potential for long-term market growth?
• How long do you have until you would need to tap into your money?

A passive investing strategy can be quite suitable for long-term investors or those who prefer a low-maintenance approach to building wealth.

Debunking Myths About Passive Investing

Passive investing is a tried-and-true investment strategy. Yet there are some misconceptions about how it works—especially in contrast to active investing approaches. 

Let’s address some common myths about passive investing and get the facts straight:

Myth 1: Passive investing is entirely “set-it-and-forget-it.”

Passive investing needs less hands-on work than active investing, but it’s not totally hands-off. You still need to pick good funds, choose how to split your money and occasionally re-evaluate your allocations. Think of it more as “set it and check it sometimes.”

Myth 2: Passive investing yields less-than-desirable results. 

Passive investing aims to match market returns. That’s a good strategy over time. Many active funds don’t even beat the market. Passive funds can at least match the market, and they often cost less than active funds. This can mean higher returns in the long run. History shows passive investing often does well compared with active strategies.

Myth 3: Passive strategies can’t be customized.

There are many types of passive funds to choose from. You can invest in broad market funds or funds for specific parts of the market. By mixing different passive funds, you can build a portfolio that fits your needs.

Myth 4: Passive investing doesn’t work in volatile markets.

Passive investing can work well in different market conditions. It helps you avoid making rash choices when markets become uncertain. Also, many passive funds spread your money across the whole market. This helps to diversify your investment portfolio.

Additional Factors When Evaluating Investment Options

All of this isn’t to say that passive investing is necessarily better than active investing. Both active and passive approaches have their place in investing. The best choice depends on your personal financial goals and circumstances.

When deciding your investment approach, consider the factors that can affect your success. Also keep in mind that military members can have unique financial situations due to their service and lifestyle. 

Here’s what to think about:

Potential tax implications

Active investing often means buying and selling assets more often. Each sale might trigger taxes on gains, leading to more taxes paid. On the other hand, passive investing usually involves less buying and selling. That could result in fewer taxes owed. Plus, passive funds tend to create fewer taxable gains, which can save money over the long run.

Your investment timeline

How long you plan to invest matters when choosing between active and passive strategies. Active investing might work better if you need money soon or want quick returns. Passive investing often is better suited for long-term goals. You’ll have more time to grow money and ride out market swings.

Your tolerance for risk

Active investing can be riskier than passive investing. It involves more frequent trading and can be affected by short-term market changes. Active investing can come with bigger swings in value. Passive investing tends to be steadier and less risky. That might be a better choice if you don’t like risk.

Unique needs of servicemembers

Passively managed investments can offer more flexibility as life situations change. This is particularly important for servicemembers who could face deployments or relocations. Servicemembers also may want a steady income from passive investments during deployments or after retirement.

Investing Definitions to Know

Throughout this guide, we’ve used terms related to both active and passive investing. To help you better understand these concepts, here are brief definitions of several important ones:

Choose investment strategies that align with your preferences.

There is no one-size-fits-all answer to the active vs. passive investing debate. Your choice should align with your financial goals, risk tolerance and investment horizon. You can find more resources about investing from Navy Federal to empower yourself with knowledge and make informed decisions to secure your financial future.

Eager to explore personalized investment options and find the right fit for your financial journey? Contact Navy Federal’s Investment Services to connect with a financial advisor in your area, or check out our online tool for do-it-yourself investors.