It's easy to get caught up in the Wall Street hype about which investment approach is better. Proponents of each believe their approach is the right one, the one that has the potential to generate the greatest amount of return over the long term.

Active vs. Passive: The Basics Active Management

Active management is simply an attempt to "beat" the market as measured by a particular benchmark or index. The S&P 500 Index is an example of an index that gauges the performance of the large-cap U.S. stock market.
Active managers believe the market can be beaten. While they can't beat
it all the time, many active managers do believe there are certain
irregularities in the market that can be taken into consideration to
achieve potentially higher returns.

Prevailing market trends, the economy, political and other current events,
and company-specific factors (such as earnings growth) all affect an active manager's decisions. The aim of active fund management - after fees are paid - is to outperform the index for a particular fund (not to mention other fund managers they may be competing against).

Advantages of Active Management:

  • Expert analysis - seasoned money managers make informed
    decisions based on experience, judgment, and prevailing market trends.
  • Possibility of higher-than-index returns - Managers aim to beat the performance of the index.
  • Defensive measures - Managers can make changes if they believe
    the market may take a downturn.

Disadvantages of Active Management:

  • Higher fees and operating expenses.
  • Mistakes may happen - there is always the risk that managers may make unwise choices on behalf of investors, which could reduce returns.
  • Style issues may interfere with performance - at any given time, a manager's style may be in or out of favor with the market, which could reduce returns.

Passive Management:

Passive management is more commonly called indexing. Indexing is an investment management approach based on investing in exactly the same securities, in the same proportions, as an index.

The management style is considered passive because portfolio managers don't make decisions about which securities to buy and sell; they simply copy the index by purchasing the same securities included in a particular stock or bond market index.

Passive managers generally believe that it is difficult to beat the market. Therefore, they essentially offer asset class performance that closely matches an index for those investors who are unwilling to assume the risks of active management.

Passive Management Advantages

  • Low operating expenses.
  • No action required - There is no decision-making required by the manager or the investor

Passive Management Disadvantages

  • Performance dictated by index - Investors must be satisfied with market returns because that is the best any index fund can do.
  • Lack of control - Managers cannot take action. Index fund managers are usually prohibited from using defensive measures, such as moving out of stocks, if the manager thinks stock prices are going to decline.

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