There are two major ways to manage an investment portfolio. Active portfolio management means actively buying and selling stocks regularly. Passive portfolio management means passively buying and holding stocks, without much activity.
Average investors can also take an active or passive approach.
An investor could do passive portfolio management, on a personal level, by hiring an advisor or buying a mutual fund. Then the advisor or mutual fund could actively manage the portfolio itself.
Or, an investor could do passive portfolio management by directing their advisor to simply buy index funds (the most popular passive investing option). Or buying a passive index fund directly.
You can see there can be many layers to portfolio management.
Let’s make it simple for average investors, starting with the pros and cons of active and passive portfolio management, in general, and then the pros and cons of active and passive management of your own portfolio.
We will discuss these points with these sections:
- Obvious Pros (and Cons) of Passive Management
- Obvious Pros (and Cons) of Active Management
- Should I Do Active Management with my Portfolio?
- Should I Do Passive Management with my Portfolio?
First let’s start with some pros and cons, based on what we know about the human condition. In other words, we are emotional and that has implications.
Obvious Pros (and Cons) of Passive Management
Investing is, arguably, more psychological than technical.
This world is filled with numbers. But those numbers are wielded for decisions, which are made by emotional human beings.
What’s so bad about being emotional?
- Well, we all crave approval. This makes us want to be part of the “in crowd.”
- Being in the “in crowd” is the worst way to pick stocks.
- You should be investing to make money responsibly, not stroke your ego. So we do things we think are clever which aren’t always good for us.
- We all crave security. The stock market provides much the opposite.
- Wanting security makes us averse to losing money.
- Being loss averse creates a fear of red (losses) in our portfolio. So we sell early to avoid this, as we frantically check our portfolios every day.
- We have a tendency to feel overconfident about our own abilities.
- A good stock pick could come from luck or skill.
- Misinterpreting good results in the random stock market can cause us to reinforce bad habits. This sets ourselves up for failure.
The harsh reality is that stock picking (active portfolio management) is hard. In fact, there are studies that suggest more active managers underperform than outperform.
It’s probably not for most average investors.
And if you were discouraged just by hearing me say that—then you are definitely not meant to be a stock picker.
In that case, a passive portfolio management approach is better suited for you.
Simply buy an index fund and passively hold it for the long term. Or, passively manage your portfolio by relying on a trusted professional to make decisions for you.
If you hear my warnings and get motivated…
Active portfolio management might be for you. If you have a rebel streak. If you find yourself wildly passionate about investing, the stock market, and businesses and numbers. If you’re not afraid of hard work and becoming humbled, again and again.
Obvious Pros (and Cons) of Active Management
Here’s why active portfolio management has bettered my life.
- I find it fascinating. It has been intellectually rewarding.
- I find it motivating. It has helped me save more, and have a reason for saving money.
- I’ve seen better results. It has taken me years to find the best strategy for my emotional temperament, and it seems to have finally bore fruit.
The fact is, a good active manager can create thousands, millions, or billions of dollars in value to clients with each 1% outperformance—when compounded over a long time.
If that puts more capital into the hands of the right people…
It could change the world for the better.
The downside to active portfolio management is that, in aggregate, there is no wealth creation. There’s only people who are beating the market taking money from people underperforming the market.
Or as Warren Buffett said,
“The stock market is a device for transferring money from the impatient to the patient.”Warren Buffett
Should I Do Active Management with my Portfolio?
There are several components to being a good active investor.
You have to know when to buy and when to sell. Which means getting real clear on your strategy—how you intend to make money and what fundamental principles will lead you to success.
You have to be constantly curious, always learning. The world is not static, and so your knowledge, insights and decision making have to be cognizant of that.
A passive management approach generally does not need either of those two things.
A passive investor can simply buy a group of stocks, and participate in stock market gains alongside the growth of the rest of the economy.
People who choose passive portfolio management generally don’t have the desire, or the time, to dedicate to mastering the craft. Or maybe they have the humility to understand that the game is too competitive for them.
That’s a GOOD thing.
Average stock market returns—which is what you get when you passively invest in index funds—will create significant amounts of compounding wealth. And it’s available to all people of all skill levels and effort levels.
There’s NOTHING wrong with average stock market returns.
If that sounds good enough for you—again, you should probably just be a passive investor.
But maybe you can’t help yourself.
Active investors need to have those qualities above, and everything that comes along within that umbrella. Even then, there is no guarantee that with the right qualities you will succeed as an active investor.
But the fact remains that the biggest beneficiaries of the stock market have been the active managers who’ve done the best (and the clients who hitched their rides to this greatness).
You have to dedicate yourself to the craft. The most famous active managers of all-time had made the stock market their life’s passion. There’s nothing like persistent effort at 110%.
Should I Do Passive Management with my Portfolio?
I really hesitate to answer that for you.
What I’ve observed is that taking the path of active portfolio management can provide you with benefits you’d never even expect.
- How many investors would’ve never invested money, ever, if they didn’t hear about the stock market?
- How can you replace the friends and acquaintances you might meet through a shared interest in picking, discussing, and analyzing stocks?
- How much additional hope does the prospect of a big gain from a stock help fuel people through a bad day, week, or year?
There are many intangibles around active vs. passive management that are not discussed much.
For me, this journey feels like it was always meant to be.
That might not be your experience, but that doesn’t mean that there aren’t benefits to trying out a little bit of both approaches, within reason.
Whatever you do, don’t go this alone.
There are endless resources, professionals, and people around you who want to help you towards your financial goals.
Rather than make a life-altering decision on passive vs active portfolio management today…
Make a decision to stop being a fool with your money. Get educated. After all,
“A fool and his money are soon parted.”
Andrew has always believed that average investors have so much potential to build wealth, through the power of patience, a long-term mindset, and compound interest.