Active Vs. Passive Investing: Which One’s Right For Me?

Active and passive investment strategies are often seen as opposites, and everyone from experienced investors to those just entering the market likely have an opinion on which is best.

In this episode of Capital Conversations, CERTIFIED FINANCIAL PLANNER™ professional Colin Day and portfolio manager Ryan Potts explore how each approach can fit into the broader spectrum of financial planning, their potential impacts on your portfolio, and how to discern which method aligns best with your financial goals.

For recent investment news and our take on the current market, retirement planning, and investment, listen to our podcast Capital Conversations or view our recent blog posts.

Below is a transcript of our most recent podcast, “Active Vs. Passive Investing: Which One's Right For Me?”

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Colin Day: Welcome back to another Capital Conversation. I'm Colin Day, CERTIFIED FINANCIAL PLANNER™ professional, and with me today, Ryan Potts. Ryan, looking good today.

Ryan Potts: Thank you. I appreciate it.

Colin Day: For all of our guests, people who are listening to this and not viewing this, Ryan is wearing a sport coat today. I am not.

Ryan Potts: I was waiting for you to say, “Where's my compliment?” No.

Colin Day: Well, we did have our quarterly investment review meeting today, and I'm assuming that's why you dressed up?

Ryan Potts: That is accurate. That is why.

Colin Day: Yeah, it was just for us. It was just an internal meeting.

Ryan Potts: It was.

Colin Day: Well, I appreciate you getting dolled up for us today.

Ryan Potts: Of course.

Colin Day: Because you knew that you were probably also going to be on camera.

Ryan Potts: I did.

Colin Day: So, what we're going to talk about today, Ryan, you're back here, you're our portfolio manager, you're our boots on the ground as it comes to investment management. So, who better to ask a bunch of questions about investment management styles?

So that's what we're going to talk about today. Specifically, what we're going to go over is what is known as active and passive investment management. Do you have something to share today in regards to those questions, do you think?

Ryan Potts: I think. Hopefully enough.

Colin Day: Okay. Well, let's gonna, we're gonna start basic. So we're gonna warm Ryan up, even though he's wearing the sport coat, he's probably already warmed up.

Let's talk about active management first. So when I say, “I want active management in my portfolio, Ryan,” define that for me.

Ryan Potts: I think that in order to understand active management, I'm going to first define passive management because it maybe makes more sense to some of the people listening. So passive investing first and then I'll flip over to active.

Passive investing is simply just going out and buying some kind of an index, some passively managed index where there is no active portfolio manager injecting their inputs or decisions on what you are going to own or what you're not going to own, or when you're going to sell or when you're going to buy.

When you think of passive investing, most people think of maybe Vanguard ETFs and going out and owning the S&P 500. Buying a Vanguard ETF that owns the S&P 500 is simply passive investing. You're just buying the market and whatever the market does, you're at the whims of it. You're going to go up and down with it. And there's no ifs, ands, or buts.

Active management, on the other hand, is when someone is interjecting their own opinions. It could be a [quantitative] model or something. But there is some sort of difference in the underlying management of what you own. That difference could be that they're overweight, underweight, certain sectors, industries, individual names. That active management could simply be when you're in and out of the market. That active management could include something like risk mitigation strategies, so basically owning the passive index, but then having additions like options and certain things that are around it to try to help with some of the volatility that comes with passive investing.

So I would say active management is just the pursuit of achieving a greater rate of return on a risk-adjusted basis, and that could be done in multiple different ways.

Colin Day: Yeah, and of course, we, as investment advisor representatives, we come up against lots of different kinds of people with different types of styles.

And a lot of it comes to, at least in my experience, how you've been brought up, how you first learned about investing, did you learn it from your uncle who was a stock picker, or somebody that was a big Boglehead (John Bogle of Vanguard fame), and for that reason, you got involved in investing in low cost instruments.

I think it's interesting because ETFs are fun from a symbol perspective, because that's the one area where people can recite their portfolios. Because if you know you're an index investor, you know what tickers are in your portfolio. ETF tickers are generally three letters or four letters, VOO, VTI, COW, all these fun, ticker symbols that become memorable to you.

Well, if you're a passive investor, you're going to know it's a portfolio and you're going to know them by the ticker symbol. So I always know when I'm talking to a passive investor by ticker symbol. Do you know what QQQ is? Do you know what SPY is?

Ryan Potts: Do they like their SPY?

Colin Day: Yeah, right, right,right. So when it comes to active and passive, oftentimes it's a versus. It's not, “I'm doing both.” [It’s,] “I'm gonna do one or the other and I have a strong reason to do one or the other.”

So, Ryan, I thought it'd be fun today if I ask you some questions. From the investor point of view, [these are] questions that I personally have received in regards to, “Hey, should I be active? Should I be passive? Or, in some situations should I do a little bit of both?”

So let's start here. Let's talk about risk for a second. I received a comment the other day from a client that said, “Hey, Colin, I am a low risk investor because I am a passive investor.” If I was to ask you if that is true or false, is that a true or false statement? “I am passive. Thus, I am more conservative.”

Ryan Potts: I would argue for the most part that that would be a false statement. But I could see the argument for both sides of the tape on that one. The reason I would say it's a false statement is predominantly as a passive investor – we can go back to 2022 for instance – when the market's down double digits, if I owned SPY or VOO in my portfolio, simple S&P 500 passive index funds, I'm going to be down the exact same as the index, regardless of what I think or believe, or maybe what I could have done differently to do better? So there is never really any risk mitigation in passive investing. You're simply along for the ride. The reality is, though, over the long term, that ride has been fairly positive over the last 80 [or] 90 years.

So, it's one of those things, “Are you taking more risk?” In theory, you're not taking more risk than what the market's already giving, but you're definitely not doing anything to protect yourself from any of the volatility that does occur in the market.

Colin Day: Right. Because – and again, if you're following along, a passive investment scheme oftentimes is just investing in some kind of index. And what we mean by that, it could be the S&P 500, which tracks the 500 largest publicly traded companies in the U. S. The Russell 2000, which focuses on more small cap companies. It could be more broad. Russell 3000. There's all these different indexes. And I can create a portfolio with the level of risk that I feel is appropriate for me in a passive way that could be way greater than somebody that's all invested in an active management strategy that could just be all bonds, as an example.

So, for me, you can build a super aggressive, passive portfolio that is super low cost. But just because it's low cost doesn't necessarily mean that there’s no risk. Just because there isn't an active component to it doesn't mean that there isn't any risk. Ryan Potts: Right. And I would say for most active managers – I alluded to it – but their goal is really to achieve the same, if not some form of better performance with a lower risk adjusted basis.

What I mean by that in layman's terms, they want to achieve – if the index does 10%, an active manager wants to achieve a 10% with a lower drawdown, or less risk as the industry would deem it. But that's ultimately their goal. And so with that in mind, that alone kind of tells you most active managers take risk into consideration when making decisions. So for them, mitigating risk is usually higher up there, on their ways to move the needle in their favor.

Colin Day: Yeah. And anecdotally – you've already pointed this out – the amount of performance that one might achieve in certain kinds of indexes over the past decade plus has led a lot of people to passive investments.

However, when we do have a year like 2022, when, well, if you're 100% in the S& P 500, well, you're going to feel 100% of the loss in that case. Again, there's the upside because when it rebounds, it does nicely. And again, over the past decade, those types of securities have done exceedingly well when compared to other people, or active managers for that matter.

And maybe that brings us to the next question here, which is, “Who is best suited to be a part of an active management strategy vs. a passive management strategy?” What say you there?

Ryan Potts: I think that that answer is it depends And there's a lot to this. So from the perspective of an investor on their own, I think you have to ask yourself, “What does it take to be a successful active investor versus what does it take to be a successful passive investor?”

From that perspective or that lens, I would say most people should be passive investors if they're managing money on their own. Just because the amount of time commitment and effort and resources that they need to put in to be a good active manager. It's not realistic for all of us to work 9 to 5 jobs and then also try to achieve some kind of alpha over the stock market when there's people who are getting paid lots of money every year to try to figure out those things. So I would say for the most part, people are better off focusing on that passive approach just because the time consumption of saying, “I'm going to own the S&P 500. I don't care where the S&P 500 goes. I'm going to own it. And I'm going to tag along for the ride for a very long period of time.”

From our perspective or maybe our shoes in terms of what our clients would benefit would benefit more from active versus passive. It always comes down to the retiree and their goals, and is the money that they have aligned with their goals? I know a few conversations ago we talked about the bucket approach. Part of me feels like within the bucket approach there’s a great area to identify active versus passive, or where would one work better than the other. For a conservative bucket of money, or your short-term goals – maybe it's emergency savings, et cetera – I wouldn't go out and buy a passive bond index and just hope that my money is secure. I would actively go out and pursue investments that I know are going to keep me relatively in line with my goals. At the same way though, you think about long-term investing, we can sit here and go through numbers all day (luckily, we're not going to for the sake of everyone else), but passive investing long-term has done phenomenally relative to active managers. I think that that's important to know, because if you're someone who's maybe on the younger side, or you have money invested in a Roth for long-term growth and appreciation, you might say, “Do I need active management in my long term bucket of money?” Or do I feel better just saying, “All right, I'm going to passively invest this into the S&P 500.”

If anything like the last 20 years is indicative of what's going to occur for the next 20 years, you'll be just fine. So I think it just really depends on your goals and, again, if you're doing it yourself, what kind of capability do you have?

Colin Day: Yeah, and when it comes to the cost conversation from a fee perspective, passive investments are, generally speaking, lower cost than active counterparts, because part of it is you're relying on experience and some of that experience comes with the time that those fund managers have put in the seat that believe, “Hey, I can beat whatever you're trying to do with a passive investment.”

But for you as an individual making investment decisions, if you are somebody that cares and is cognizant of how you're diversified and making investment decisions, well, you've got to put some effort in there, right? You're probably not just going to sit back and say, “That one looks good.” Click “Buy.” You're probably going to spend some time having either an internal conversation with yourself, maybe speaking with your friends, maybe looking things up online, making an educated decision then as to how you're going to purchase. And if you value your time at a dollar amount, well, technically, you should consider that as part of your cost of being a passive investor.

So, it's just a little bit different than the mindset of just saying, “Hey, this is the low cost solution. I put my money in. I'm going to put it all on red, and hope that it works out for myself.” I am going to spend some time, again, whether it's actual money or internally, billing myself for my own hours.

I think about it the same way as cleaning my house. I value myself at blank number of dollars per hour when I'm sitting in my seat working with a client. If that's greater than me begging off early, going home, cleaning my floors, vacuuming my floors, well, I should be here, I should be doing this, I should pay somebody to do that other thing.

And that's really what active management is all about, right? You're paying somebody for their experience and their time.

Ryan Potts: I'm just going to add on to that. I think like the last 15, 20 years, really the last 10, has put a notion in most investors’ minds that it's so easy to just put money in the S&P 500 and let it ride.

Bring me someone that's been invested in the S&P 500 for the last 10, 20 years and has never touched their money, never panicked once, never, had those kinds of qualms with wanting to change it. Bring me someone like that because I have yet to meet them, right? Most people somewhere along the way have kind of an internal conversation with themselves. Is this worth the headache? Yada, yada, yada.

You talk about your time. I also think about, when I've got a runny nose – which I may or may not, you can't tell – when I have a runny nose I can self diagnose. Typically it's allergies or maybe just a seasonal cold or something like that. I'll run to CVS, grab some medicine. I move on with my day. If I felt much sicker than that though, I probably am going to see a doctor because I really value their expertise and their opinion.

I think investing is the same way. The last 10 years it's been so easy to just kind of sit back and feel good about everything. I think if you're someone who's getting closer to retirement and have those bigger question marks in mind, it's always nice to have an expert opinion in the room. And to your point about fees, you stressing and some of the things emotionally that come with being an active investor or someone that does it themselves, that's also a cost that you have to take into consideration. Is this keeping me up at night worrying about a decision that I made or didn't make?

Colin Day: Yeah. There was an article I read, I think it was a couple of days ago at this point, it was about how advisors can basically quantify the results of a client as to why you pay fees. It's the same thing with a fund manager. Really, if you're just judging it on short periods of time, “Hey, this year, my passive investment, my S&P 500 index fund performed better than the active manager in my portfolio. I'm going to dump the active manager and move everything to the S&P.”

Well, that's not a good judgment of performance because that was just a small window of time. And, especially with our retirement plans that we take care of where we're dealing with people's investments for decades, 40, 60 years depending on when they come to us. We're looking at it from an angle of saying like well, yeah, “What have you done for me lately?”

And yeah, right now passive investments have won. One of the questions we were going to talk about was what performs better? Passive investors, anecdotally, tend to do better than active managers. Active managers struggle to find alpha, to improve the results of whatever index you're trying to track.

As investment managers and as well as advisors, the angle that we're trying to say is, “Well, yes, I know that over this time period, this has done well. Were you in the market 100% of the time?” Most of the time, no. There's going to be times where they bail. Well, okay, “What are the time periods past that you did this?” Were you doing a different strategy or didn't work with an advisor? I've been messing around with my investments for a long time. All these questions get raised in regards to, “What actually is the best result?” And I, for one, as I think Ryan would attest, we're fine with passive investors. To each their own.

It's just the reality that we can tell our own story in regards to how we're treating our accounts and how we handle them over periods. But the truth is a little bit harder to get to in anything and that's why we say “anecdotally,” or “maybe,” or “it depends.” Because so many times the types of things we want to answer are really hard, hairy questions. Even in this podcast, we're not going to be able to really answer the passive versus active debate.

Well, let's get to another question for the sake of time. So what areas in the market do we see passive management perform better or active management perform better? Is there a reason I should be active in a particular space versus another one?

Ryan Potts: Without getting too technical here – so pause me if I do – really the question about what areas of the market do maybe active outperform passive or vice versa is more of a question of where or what parts of the market are efficient versus what parts of the market are inefficient.

Colin Day: Okay.

Ryan Potts: And I'm not going to go much deeper than that, other than for those listening who don't know what efficient markets are. Basically, it's just the theory or idea that public knowledge is public and it's available immediately. So there's no like smoke and mirrors, anything going on behind the scenes that would set anybody apart from anyone else. Because all the information that you would need to make an investment decision is immediately publicly available.

So you think about the S&P 500 when news comes out about any particular stock or the economy or inflation for that matter, everyone that's in the market is interpreting that data immediately at the same time, and it's being spilled over into the markets. If it's plus, minus, whatever the case may be. We would argue that in a market like the United States with the S&P 500, or the NASDAQ, or the Dow Jones, there are literally billions of dollars in resources going into the research and the capabilities of management, and following along with these companies.

So we would argue that those markets are probably very efficient. That data is super easy to get our hands on and everyone reacts to it in a relatively similar way. Now, in a market like maybe emerging markets, something like India, this emerging economy that is extremely fruitful with opportunity. Have you read an article in the last six months about an Indian business?

Colin Day: Personally, no.

Ryan Potts: Okay. I haven't either. And that's the whole point of my conversation. Maybe emerging markets is an area where not all of us have readily available data to process decision making. And so finding managers who are a little bit more specialist or niche in their abilities to go and explore certain areas of the market that maybe aren't as efficient.

We kind of think of it in this way: Large cap domestic names. So the S&P 500, the NASDAQ, we would say predominantly are efficient markets, and so owning a passive index is a great solution.

Then when you look at something like small caps, internationals, emerging markets, fixed income alternatives, these different asset classes, there's definitely a large difference between the best manager versus the worst managers, and also where their passive indexes fall in the middle there.

Colin Day: Okay, cool. Well, I've got one last question for you. It was just asked of me today. “What age should I be a passive versus an active investor? Maybe I'm approaching retirement, maybe I'm just out of school and just trying to get my feet wet in the marketplace. Is there a reason I should be one or the other at a particular age?”

Ryan Potts: I don't think there's a reason to do one or the other at any particular age. The only kind of advice that I could give on this is, for someone who's nearing retirement, is in retirement, has maybe a lower time horizon – just simply from the fact that they might not be living as long as someone who's 20 or 30 years old – they might benefit more from active management just from again, the perspective of there is some downside protection with active management. And there are some things that you can do to mitigate your outcomes in retirement. For someone who's younger – my age, your age – we might benefit more from passive investing simply because it's cheaper and over long periods of time it's been proven to outperform most active managers.

So it might make sense for us to say, “Hey I'm gonna throw all my money right now on the S&P 500 and let it ride.” That is not advice. Do not do that. But that's the way I would think of it. If you know your goals or you know what outcomes you're looking for out of your money, being active is definitely the way to go. If you're simply just investing for the future and that future is unknown, having your money in the market is more important than anything else that we can talk about today.

Colin Day: Yeah, absolutely. I think the default investment for many many many 401(k) plans right now are some kind of target date fund. And many of those target date funds, the underlying investments of them are passive index investments And that's – for I think a lot of young folks that are just getting on the journey of saving for retirement – it's not a bad way certainly to get involved because those target date securities are diversified between lots of different market sectors. They're just trying a very broad approach, a shotgun style, as opposed to trying to be very nuanced, like many active managers might be.

So for me, many investors of that variety that are just getting started are probably doing that very passive approach. But yeah, I agree with your comment that perhaps the older you get, perhaps the closer that money that you've been saving up for all these years becomes more and more real, we want to make sure that, “Hey, listen, active management might benefit you.” It might not benefit you from the angle of investment performance on the upside, especially if you're going to judge against a market index – which doesn't actually reflect your underlying portfolio in terms of what you invest in, but that’s another story – but rather from the angle of saying like, “Hey, I need you to sleep well at night so that you can enjoy your retirement for as long as possible.” And that might just mean that we have to be a little bit more active in the strategies and have a closer eye on the things that we're doing underneath those accounts.

So, with that being said, Ryan, any parting thoughts for our audience?

Ryan Potts: No, I think it's a fun debate. I'm glad we didn't go into it too much. could sit here for hours and talk about it.

Colin Day: We debated that too.

Ryan Potts: We did. I think that ultimately it's just a preference of what are you comfortable with above all else? Money is just a tool to help hopefully bring you happiness. And if you're stressing about trying to be an active manager and picking your own stocks, is it worth the stress? I love it. It's definitely making my hair gray though. So it's kind of one of those things. It's a trade off.

Colin Day: Come on. There's no gray hairs in that mustache.

Ryan, thanks again for joining today on another Capital Conversation. Appreciate you having some time with me today.

Ryan Potts: I appreciate it, Colin. Thank you so much.

Colin Day: All right. And thanks to all of you. Like and subscribe, all that social media jazz, if you haven't already.

And until next time for Ryan Potts, Colin Day, thanks so much.

The opinions expressed in this program are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. It is only intended to provide education about the financial industry. To determine which investments may be appropriate for you, consult your financial advisor prior to investing.

As always, please remember investing involves risk and possible loss of principal capital. Please seek advice from a licensed professional. Correct Capital Wealth Management is a registered investment advisor. Advisory services are only offered.

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