When I first read Ben Graham’s value investing bible, The Intelligent Investor, I became hooked on investing and finance. The whole idea of letting your money work for you really appealed to me. In the book, Graham alluded to the idea of passive and active investing.

Graham described two different types of investors: defensive investors and enterprising investors. Defensive investors want to limit the risks of their investments and also spend less time managing a portfolio. On the other side, enterprising investors love to spend the extra time to really research companies to hopefully achieve superior returns.

Passive Investing

Passive investors are in many ways like Ben Graham’s description of defensive investors. These investors want exposure to the stock market, but do not wish to spend hours and hours performing research.

As a result, passive investors typically own some kind of index or ETF that mimics the performance of the broader market (i.e. the S&P 500 or the Dow).

These investors are not interested in timing the market or making ‘home run’ investments. They want to spend as little time researching, while still reaping the wonderful benefits of compound interest.

Before talking about the advantages and disadvantages of passive investing, I wanted to discuss passively investing in active fund managers.

Most active mutual fund managers should be avoided because the fees ARE NOT justified. Don’t get me wrong, if the manager charges an extra 1% in fees but generates returns 1,000 bps above the market it is definitely worthwhile to park your money there.

However, in recent years, many fund managers have not beaten their benchmarks. It would be much better just investing in a passive index fund.

Advantages of passive investing:

1. Low stress:  When you invest in a passive index, it is much less stressful than actually picking your own stocks. When the market rises you get wealthier and when it falls you lose some money. Markets go up in the long-term (20 – 30 years), so you can be virtually guaranteed to make money over the long-term.

2. Less time-consuming: Active investing can be time consuming. From spending time researching a company, its competitors, talking to customers and suppliers, and reading through filings, it can be another full time job! With passive investing all you have to do is execute a trade periodically. You can spend the extra time making extra money with side hustles or spend more time with family!

3. Easy to execute: Passive indexing is an easy strategy to execute. All you need to do is save money periodically and invest it in the market! No need to worry about timing the market or anything like that. Just “buy and forget.”

4. More tax efficient: With passive investing, you are investing in the market for the long-term. When you sell a stock (for a gain) you pay taxes, which disrupts the magic of compound interest. The longer you invest, the longer your interest has to compound without the penalty of taxes.

Disadvantages of passive investing:

1. Average returns: When you invest in a market index you are by default accepting the average market return. With active investing, you could potentially achieve much higher returns.

2. It can “get boring”: One of the most common complaints I hear about passive investing is “it’s so boring.” While passive investing may not seem as exciting as day trading, it is much more profitable in the long term. Never day trade.

Active Investing

Active investors are similar to Ben Graham’s enterprising investor. These are individuals who are not satisfied with achieving the average market return. They want superior returns! Active investors are willing to sink in countless hours screening, researching, reading through filings, interviewing industry participants, and building models.

These investors are seeking the best companies to invest in to make above average returns. In my experience, active investing is not suitable for some people because they lack the necessary time to invest in quality research or they lack the proper skill set and emotional qualities…but that’s totally okay because you don’t have to generate above average returns to become wealthy from the stock market!

Advantages of active investing:

1. Potential to beat the market and generate superior returns:  The main goal of any active investor is to beat the market. If you could beat the market by even a small margin, say 3% every year, then over the course of 25 years, you would have twice the profit of an index fund!

2. Set your risk tolerances: Everyone has different risk tolerances depending on their age, financial condition, or mindset. With active investing, you can be more aggressive in individual stock picks or more conservative.

Disadvantages of active investing:

1. Much riskier and more volatile: Active investing can be very dangerous (especially for the inexperienced). Look at how so many hedge funds have underperformed in recent years! These are guys with billions of dollars and more degrees than James Franco! With active investing your returns can be much more volatile than passive investing.

2. Trading costs much higher: With most online trading brokerages, you can buy an index that mimics the S&P 500 for less than $10. Most active investors pay $7+ to trade individual stocks. To build a portfolio of 20 stocks would cost over $140!

3. Time consuming and stressful:  Active investing can be a time consuming process. That time may be better spent working on side hustles or spending time with family and friends. Plus, individual stocks are always more volatile than the overall market. It may be stressful for some people to see a stock they own drop by 10% in one month and then rise by 15% the next month.

Which Is Better For You?

Before I discuss which one is ‘better’, I have to caveat that it really does differ on an individual basis. Investing strategies always depends on age, financial situation, risk tolerance, and many other factors.

That being said, for the majority of people, I believe passive investing is the better strategy. It is less time consuming and stressful, but will still allow you to generate substantial wealth over the long-term. You don’t need to generate 25% returns a year to become wealthy.

Now don’t get me wrong, active investing can be great for many people as well. A lot of fellow bloggers out there operate highly successful dividend growth portfolios.

Personally, I use both strategies. I have a passive portfolio where I invest in an index fund and I also have a separate active portfolio where I invest in individual stocks. It’s a good strategy that works for me and that’s what matters.

Take Action Now

Due to the magic of compound interest, it is always better to invest early. I would highly recommend you do two things to get started.

First, sign up for Personal Capital to manage your portfolio. It is a FREE wealth management tool that aggregates all of your investments accounts together. It also has amazing tools to manage investment fees, calculate retirement scenarios, and manage spending and savings. Check out my review here or click here to sign up!

Second, sign up for Motif Investing. It is a great online brokerage solution. Motif allows you to purchase a portfolio of up to 30 stocks for one low commission of $9.95. It costs $7+ to trade just one stock on most online brokerages. So if you tried to build a portfolio of 30 stocks with another online platform, it would cost over $210! Click here to sign up now!

Conclusion

There are many pros and cons for both passive and active investing. Not everyone has the same risk tolerance, financial goals, or even financial condition. As a result, you should choose the best strategy to match your lifestyle and to help achieve your goals.

Readers: I am very interested in hearing your thoughts on the subject. Do you support passive or active investing and why?