Passive and active investing explained
Guide Summary
- Passive investing tracks the market and is typically low-cost, making it ideal for beginners.
- Active investing seeks to outperform the market but involves higher costs and more risk.
- A blended strategy could provide a balance between simplicity and potential outperformance.
What is passive investing?
Passive investing is a long-term investment strategy that aims to replicate the performance of a market index, rather than trying to beat it.
Investors typically buy into funds, such as index funds or exchange-traded funds (ETFs), that track a broad market benchmark like the FTSE 100 or S&P 500.
Key passive investing characteristics
- Low cost: Passive funds generally have lower fees because they require minimal management.
- Buy-and-hold approach: Passive investors aim to ride out market ups and downs over time.
- Diversification: Tracking an index provides exposure to a wide range of companies.
What is active investing?
Active investing involves ongoing decision-making to buy, hold, or sell assets in an attempt to outperform the market.
This strategy is often managed by fund managers or individual investors who analyse market trends, company performance, and economic indicators to make investment choices.
Key active investing characteristics
- Higher costs: Fund management, research, and transaction fees tend to be higher.
- Tactical decisions: Active managers may buy or sell holdings frequently to exploit market opportunities.
- Potential for higher returns: Success depends on skill, timing, and market conditions.
The advantages and disadvantages of passive investing
Advantages of passive investing include:
- Lower fees: Less management means reduced ongoing costs.
- Simplicity: Ideal for beginners; less time and knowledge required.
- Market-matching performance: Often performs better than many actively managed funds over the long term.
Disadvantages of passive investing include:
- No chance to outperform the market: Returns will always closely mirror the index.
- Limited flexibility: Can’t adjust quickly to market shifts or exploit short-term opportunities.
- Market downturns: Passive funds track indexes even during declines, with no defensive measures in place.
The advantages and disadvantages of active investing
Advantages of active investing include:
- Opportunity for higher returns: Skilled asset managers can outperform the market, especially in less efficient markets.
- Flexibility: Managers can pivot strategies in response to changing conditions.
- Tailored investment strategies: Portfolios can be aligned with specific goals or themes (e.g., ethical investing, emerging markets).
Disadvantages of active investing include:
- Higher costs: Active funds charge more, which can eat into returns.
- Greater risk of underperformance: Many active funds fail to beat their benchmarks after fees.
- Requires more research and monitoring: Not ideal for novice investors or those short on time.
Is active or passive investing right for me?
Choosing between active and passive investing depends on your goals, how much time you want to dedicate to managing your investments, and how comfortable you are with risk.
If you're just starting out, passive investing is often a practical and beginner-friendly option. It requires little ongoing effort, keeps costs low, and provides broad exposure to the market. It’s especially suited to long-term investors who prefer a “set it and forget it” approach and are happy with market-average returns.
On the other hand, if you're someone who enjoys researching companies, keeping up with economic trends, and believes in your ability (or that of a professional) to spot investment opportunities, active investing might appeal to you.
It offers the potential for higher returns but comes with more risk, higher fees, and a greater time commitment.
You should also consider your risk tolerance. Passive investing tends to be more stable and predictable, while active investing can be more volatile, especially over shorter periods.
Importantly, you don’t have to choose one or the other. Many investors find that a blend of both, using passive strategies for long-term stability and active ones for targeted opportunities, gives them the best of both worlds.
How to combine active and passive investing
Many investors choose a blended approach, combining both active and passive strategies to balance cost, control, and opportunity.
Common combinations:
- Core and satellite: Use a passive fund for the core of your portfolio, with smaller “satellite” allocations to active funds targeting specific sectors or regions.
- Thematic investing: Stick with passive index funds for broad market exposure and add active investments in areas you believe have strong growth potential.
- Rebalancing over time: Start passive, then explore active strategies as your confidence and knowledge grow.
This approach allows flexibility while keeping fees manageable and risk diversified.
Passive and active investing summary
Understanding the core differences between passive and active investing is essential for building a strategy that suits your financial goals and comfort level.
While passive investing offers cost-efficiency and simplicity, active investing presents opportunities for higher returns, albeit with added risk and effort. Ultimately, there's no one-size-fits-all answer. Many UK investors successfully use a mix of both approaches to suit their needs.
In the next guide in our Investment Strategies series, we’ll explore another foundational concept: Growth Investing vs Value Investing, two popular approaches to selecting individual stocks.
When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than your original investment. Chip does not offer financial advice and this should not be considered as a personal recommendation. Diversifying means spreading your investments across different sectors, countries and asset classes.
