Investment decisions need in-depth research and analysis to make sure that there is a correct mix of investments in your portfolio. Doing so ensures return maximization in the long term. Also, you must keep in mind that the investment cost is not very high, which might eventually lower your returns. You can select various investment avenues based upon different parameters like return expectation, investment budget, risk factors, etc. However, broadly, there are 2 major investment forms: passive investing and active investing.
Active investing is when investors use an active investment strategy to earn higher returns. An active investment strategy is of 2 kinds: investment in the actively managed funds where fund managers are the decision-makers and investment on your own using thorough analysis and market research. It is based on the proper use of different investment strategies and knowledge of when to exit and enter the market to attain maximum returns. The risk factor in active investing is extremely high and hence, you must be cautious about your investments. It is suitable for you if you have a high-risk tolerance level. Active fund examples include equity funds, leveraged funds, etc.
Passive investing, on the other hand, is a safer investment mode in the stock market. Passive investing is an investment in passively managed funds. Such funds follow underlying assets or indexes for their returns. Unlike active funds, there is zero pressure for generating higher returns and outperforming the market. Returns via passive investing are a replication of underlying assets or indexes or security which fund tracks for their performance. Passive investing examples include index funds and ETFs.
Here are major reasons why passive investing is steadily attaining higher preference amongst investors:
Purchase and hold approach
Passive investing adopts the principle that market indices grow upward over a long period. For example, Sensex was nearly 5,000 points in the 2000s, however, now it is near 55k points. Thus, passive investing permits you to purchase and hold the assets for the long term instead of changing the market strategies as well as risking your returns. Passive investing can be profitable if you stay invested for the long term.
Higher returns over the long term
When it is about active vs passive investing, the latter often outperforms in the long run. Fund managers of the active funds try to outperform the benchmark index returns. However, in current years, active funds have considerably underperformed in the long run. As per the SPIVA mid-year 2021 data, more than 86 percent of the active equity large-cap were beaten by S&P BSE 100 over the past 1-year period, and this number was almost the same for 3- and 5-year periods, with the underperformance of 87 percent and 83 percent, respectively.
Passive investing means mirroring market index portfolios. This strategy helps in diversifying your portfolio across companies and sectors. Thus, your investments are completely safe from company-specific or sector-specific downturns.
When investing in active funds, you must pay the fund manager a fee called an expense ratio. The expense ratio is a percentage of your overall returns. As in the case of passive investing, fund managers do not manage the passive funds actively, its expense ratio is mostly low. When investing in passive funds via the SIP route, you avail the benefit of compounding effect and substantial returns over the long run. So, for the passive and active fund that yields a similar return, your returns in passive funds will be higher as you will not require paying a heavy expense ratio.
In conclusion, opting for passive investing is one of the cost-effective and best ways to form huge wealth over the long run, particularly if you do not hold the expertise or lack the time to pick as well as monitor your investment portfolio and want to remain invested for the long run.