With surprising regularity, the investing world revisits a conversation that’s been going on for years. Should investors choose the cost-effective paragon of simplicity known as passive investing or should they turn to active management for the insights of professional portfolio managers? All too often, investors feel like they need to choose one or the other.
But that seems a bit extreme. While active and passive investing may give the appearance of rival strategies, they can work in concert to help your portfolio grow. Let’s explain.
A tale of two philosophies
Imagine there are two ways to navigate a fast-flowing river.
One way involves building a sturdy raft designed to ride the current. There’s no steering involved. The traveler depends on the river’s momentum to be carried downstream. Passive investment strategies are just like the raft, moving with the market as the raft moves with the river. These strategies are constructed to be simple and cost-effective. The goal isn't to beat the market but to perform as the market, capturing its returns by tracking a broad index like the S&P 500.1
The other approach is to captain a riverboat. The boat’s pilot studies the river's currents, weather patterns, and geography. They believe that with skill, research, and flexibility, they can find faster channels, avoid dangerous currents, and reach the destination more efficiently. Active managers are like the riverboat captain; they base their investment strategy on their experience and specialized knowledge. An active manager believes that their knowledge and skill should allow them to select stocks and other securities that they believe can outperform the overall market.
The conversation often stops here: Choose between the raft and the riverboat. The intelligent investor understands that it’s possible to take advantage of both for different parts of the journey.
How active vs passive investing misses the point
The debate between active and passive is so often framed as a zero-sum game, where one type of strategy must beat the other. But sometimes that can miss the point and the unique role each strategy can play.
For example, passive investing, through low-cost index funds or ETFs, provides broad, diversified exposure. It can be a dependable core of a portfolio, the part that ensures investors are participating in the market's long-term growth. It's a bet on the enduring power of the entire forest, not just certain individual trees.
Active investing, on the other hand, is about targeted conviction. It makes it possible to express a specific viewpoint or gain exposure to areas of the market where simple indexing might fall short. Think of emerging technologies, smaller companies, or specific economic trends. These are market sectors where deep research and a willingness to deviate from the index may create a significant advantage. It’s a bet that a skilled professional portfolio manager could find the tallest trees in the forest.
But even the best strategy in the world is useless when an investor can’t stick with it. For some people, the simplicity and low-maintenance nature of a passive strategy make it easier to stay invested through market gyrations. For others, the research and conviction behind an active choice provide the confidence to hold the line during volatility. The right strategy for an investor is usually the one that keeps them from panicking when the going gets turbulent.
Assembling an all-star team
Instead of seeing these strategies as the Yankees and Red Sox of the investment world, think of them as different players on a portfolio’s team, each with a specific job to do. How you combine them depends on your personal goals, time horizon, and current market conditions.
Building with passive investing
For many investors, a core of low-cost passive funds can be a sensible choice. This can provide a solid foundation of diversification across major markets, like U.S. large-cap stocks. This part of your portfolio is the raft, reliably moving with the market’s current. It’s the steady, all-star player who shows up every game and delivers a consistent performance. This is the power of a passive strategy.
Building with active investing
Your active positions can serve as specialists, brought in to execute specific plays, such as:
- Exploring new frontiers: Want to invest in the disruptive potential of artificial intelligence or biotechnology? An active manager specializing in these sectors may be able to perform the deep research needed to identify potential winners in a rapidly evolving field.
- Navigating tricky currents: In certain markets, for example, high-yield bonds or emerging economies, the differences between winners and losers can be marked. An experienced and deeply informed active manager can be invaluable here.
- Seeking unique opportunities: Active management isn’t limited to just picking stocks. An active strategy can offer the flexibility to help manage risk, adjust a portfolio's exposure based on macroeconomic trends, or take advantage of short-term market dislocations in ways a passive index cannot.
By combining the two, investors can leverage the best aspect of each strategy. You have the broad, cost-effective market exposure of passive investing and the targeted, conviction-driven potential of active investing. The raft keeps moving with the main current, while the riverboats explore promising tributaries along the way.
The takeaway
The conversation about active vs. passive investing is not about finding just one winner. It’s about building a more resilient portfolio that is tailored to an investor’s individual needs. It's about recognizing that investing decisions are rarely about simple binaries.
The market is not static; it's dynamic and ever-changing. There will be times when the broad current of the market is all that’s necessary, and a passive approach may produce the desired results. There will be other times when specialized knowledge, experience, foresight, and flexibility to navigate changing conditions will make all the difference.
Embracing both philosophies can give an investor more tools to pursue their objectives. Use passive strategies for their simplicity and cost efficiency in well-trodden parts of the market. Deploy active strategies to express conviction and seek opportunities in less efficient sectors. These strategies can be exceptional partners in your long-term financial journey.
At Motley Fool Asset Management, we’ve long been believers in using active and passive ETFs to navigate today’s market. Explore our lineup of ETFs.
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