What is active investing?
Active investing, also called active management, is a type of investment strategy that involves the ongoing monitoring of a financial market in order to frequently buy and sell financial securities, aiming to beat a benchmark index and generate short-term profits.
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Understanding active investing as an investing strategy
Active investing refers to a ‘hands-on’ approach in which a portfolio manager (investment manager) or active investor constantly monitor price movements of financial assets in financial markets. The aim of those who use active management as an investment strategy is to ‘time’ a financial market, which is a strategy that involves buying and selling financial assets based on expected price movements in the future. Timing a market correctly is a risky strategy which often fails because it is challenging for active investors and managers to generate significant profits by accurately timing buy and sell orders right before prices move up and down. Active management usually overlook long-term trends and focus on short-term profits. This explains why active investors frequently use technical analyses such as moving average convergence divergence (MACD), relative strength index (RSI), and ratio analysis, to name a few. Active investors apply, inter alia, the following methods to make informed decisions:- They conduct an in-depth analysis of each investment before deciding to invest or not to invest. Such an analysis determines which financial securities are under-priced and will presumably outperform the market or which are currently overvalued.
- Financial statements.
- Growth strategies of the company.
- Developing trends (short and long-term) in the market.
- Macroeconomic factors (locally and globally).
- The true value of a stock (intrinsic value) versus its current trading price.
- WallStreetMojo mentions that active investing comprises the following methods, amongst others:
- The services of portfolio managers and research analysts are used to gain higher returns than the benchmark indexes like S&P 500, NASDAQ Composite, and Dow Jones Industrial Average.
- It makes the most of impending opportunities and diligently react to changing market conditions. Investment decisions are not based on emotions, or the historical performance of a financial asset.
- ‘They [active investors] customize portfolios to meet their goal of generating wealth in a short period of time.’
- Furthermore, investment portfolios are based on the risk tolerance and investment goal of an investor.
- Active investing is prone to additional fees (for instance, commissions) if the number of trading transactions executed during a trading day is too high. In addition, active investors are required to pay a substantial fee to fund managers, making active investing more expensive than passive investing.
Pros of active investing
Proponents of active investing give the following reasons, amongst others, why active investing is a better choice than passive investing.- Active investing is flexible, providing excellent opportunities to pursue high returns in the financial markets.
- Active fund managers are allowed to change and mix the assets under their management and can focus on the most favourable investment. Express differently, active investing enables fund managers (also known as money managers) to adjust the portfolios of investors to align with dominant market conditions. This strategy helps managers to mitigate investment risks. Furthermore, active managers enjoy flexibility, meaning they are not required to follow a specific financial index such as the S&P 500.
- An active investing strategy allows active investors to hedge their trading positions by applying numerous trading techniques such as put options and short sales. In addition, they can get rid of specific financial assets or sectors when the risks are too high.
- It provides the advantage of short-term trading opportunities. For example, a speculative trading strategy such as swing trading can be executed, aiming to generate a profit from expected price moves. Typically, swing trades are held for one to six days. However, the period may be as long as two weeks.
- Active investing enables fund managers to satisfy the specific needs of their clients. Needs like retirement income, a diversified investment portfolio, or a specified investment return.
Cons of active investing
The opponents of active investing and the proponents of passive investing name the following disadvantages of active management:- Although active investing can generate higher returns, the strategy involves high fees because of factors such as:
- The active buying and selling of financial assets.
- Fees for the fund manager’s management and expertise, as well as administration costs.
- Active trading poses high risks. For example, managers of active funds are allowed to acquire any investment they consider to be a vehicle of significant returns. This is a great advantage when the decision of a fund manager is correct, but extremely bad when it is wrong.
- Active investing is extremely volatile because financial markets are affected by small and big changes in the macroeconomy, as well as political turmoil.
- Some active investment funds require investment thresholds from prospective investors.
Differences between active investing and passive investing
Contrary to active investing, passive investing refers to a long-term investment strategy wherein investors aim to earn maximum returns over a long period of time by buying financial assets and holding them. Some of the differences between the two investing strategies are listed below: Active Investing Passive Investing Fund managers are allowed to actively change the composition of an active fund at their own discretion Passive fund managers are obliged to hold the securities that are included in the index they track, despite their performance The goal is to generate short-term profits The aim is to earn long-term profits Fund managers aim to outperform financial markets or to generate stable returns, notwithstanding market conditions Fund managers try to match returns with those of benchmark indexes It involves frequent buying and selling of financial securities based on price movements Investments are acquired and hold over long periods of time Prone to high risk because fund managers often fail to match or outperform benchmark indexes Low risk involved Expenses are higher due to the time, managers, and resources involved It is less costly than active trading due to infrequent portfolio adjustments Can generate high returns, although, high returns are associated with high investment risk It typically gives low or moderate returns, but has much lower risk than active management
The choice between active investing and passive investing
Proponents and opponents of active and passive investing have justifiable arguments for, or against, each type of investing. Each strategy has its own pros and cons that investors have to consider. Furthermore, there is no final or correct answer on which approach is the best one, because an answer is typically based on subjectivity and factors such as the following, amongst others:- The unique investment goals of an investor
- Risk tolerance
- Personal financial and investment goals
- Time period of investment
- Size of investment portfolio
- Comfort level
- Age
- Transaction costs
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