Active vs. Passive Investing

Choosing the Best Investment Style for Your Portfolio

Most investment professionals subscribe to the Efficient Market Hypothesis (“EMH”), which states that it’s impossible to “beat the market” because market efficiency causes existing prices to always incorporate and reflect all available information. Since it’s impossible to beat the market, these passive investors prefer investments like exchange-traded funds (“ETFs”) or mutual funds that hold broad baskets of stocks in order to participate in market upside.

Those rejecting the EMH point toward successful investors like Warren Buffett or Peter Lynch as evidence that it’s possible to be the market. In general, these active investors believe that there are inefficiencies in the market that can be exploited for profit. These inefficiencies may include out-of-favor stocks trading below their intrinsic value or small-cap stocks that have simply gone unnoticed by larger institutional investors that are focused on bigger competitors.

In this article, we’ll take a look at these two approaches to investing and how investors can choose between them when looking at international opportunities.

Passive Investing for the Long-term

Most investors are best off with a passive investment strategy, since it doesn’t require any hands-on effort over time. By broadly investing in developed and emerging markets evenly around the world, investors don’t have to worry about following any particular country or security that they’re invested in to make sure it’s still sound.

The fees associated with passive investing also tend to be much lower, which is an easy way to enhance returns.

When passive investing, investors should focus on assessing the level of risk they’re comfortable taking before building a portfolio around it. Younger investors willing to assume greater risks may want to take a look at riskier foreign markets – such as emerging or frontier markets – while older investors looking to preserve their capital may want to consider all-world funds or investing in more stable developed countries when looking abroad.

Hands-On Active Investing

Some investors like to take a hands-on active investment approach with the belief that they’re able to beat the market over time. Since they’re selecting specific regions, countries, or securities they believe will outperform, these investors must spend a greater amount of time analyzing various opportunities and finding alpha. The fees associated with active investments tend to be higher when going with “active” ETFs or mutual funds.

When active investing, investors can either look at macroeconomic trends, intrinsic valuations, or relative valuations to identify markets or securities that are potentially undervalued. The second big step in the process is timing the market to ensure they aren’t buying or selling too early or late, which can result in either opportunity costs or actual losses. These investors may want to consider country ETFs, American Depositary Receipts, or foreign direct investment.

Key Takeaway Points

  • Passive investing entails purchasing a broad group of international stocks with the goal of making the market average in returns over time.
  • Active investing entails selecting individual regions, countries, or securities that an investor believes will outperform the market.
  • Most investors are probably best off with passive investments, but active investments have their place for the hands-on investor.
  • Some investors may want to consider employing a mix of passive and active investing approaches in order to maximize the benefits of both techniques.