Active vs. Passive Investing: Finding the Sweet Spot

By Harvey Investment Management on August 8, 2019

When it comes to investing strategies, people generally choose either an active or passive approach, depending upon their needs and risk tolerance level.

The term “active investing” refers to a strategy in which the investor typically works with a portfolio manager to buy and sell securities on their behalf. They actively make decisions regarding investments based on a given criteria and changing market conditions.  It is a risk managed approach to investing. In these strategies, there is a screening methodology that indicates, for example, that you should purchase shares of Facebook versus General Electric.

“Passive investing,” on the other hand, refers to a “set it and forget it” strategy.  Few real-time decisions are made about investments; instead, a market index is followed. Think of it like setting cruise control in your car — in a passive approach, investors or their portfolio managers pick their allocation percentages and do not make changes based on market conditions. Passive investing in indexes can include broad market indexes like the S&P 500 or small cap indexes like the Russell 2000. They may also include sector indexes (like technology or healthcare) or non-stock investments (like bonds and commodities).

In the fourth quarter of 2018, the U.S. stock market sold off with great ferocity, catching many investors and portfolio managers alike off guard. If you employed an active investment strategy, then you watched the rise and fall of stocks and made adjustments accordingly, hopefully limiting your losses. However, if you employed a passive strategy, then although you saw the same rise and fall of stocks, you did not make changes to your portfolio based upon current market conditions.

The portfolios that tend to do well over time have a structured or disciplined element that guides making changes to investment allocations. It is helpful to have someone overseeing portfolios, as people tend to make emotional decisions at the wrong time. For example, if a portfolio goes down by 10 or 20% and the investor sells half of the portfolio and moves that money to cash without a disciplined approach to get reinvested, then the market timing can be very damaging to the long-term portfolio performance.

There is a third approach to investing, a hybrid approach, in which the portfolio is made up of components of passive investments. Objective criteria is followed that indicates when to change the weighting of passive investments within the portfolios based upon current market trends. This is called a “trend following” approach, which has historically reduced draw down (or major losses) in times of great stress.

An analogy that we frequently use to explain our hybrid approach is taking a road trip using the interstate between two cities. In our analogy, the interstate represents our passive investment. It is how we are going to get to our destination.  The destination represents retirement (our end goal).

Before we get on the interstate, there are several decisions that must be made, including: what car to take, what day and time to leave and how fast we will drive. All these decisions impact how long it takes for us to get to our destination.  We also will take into consideration the condition of our car, the weather and traffic conditions.  If, for example, there is a major snowstorm and the interstate is our only option to get to our destination, then we might delay our trip until the roads are clear. This analogy shows how we can use an active overlay on top of a passive strategy. In our example, we have not changed our destination or the road we will take. Instead, we are adjusting what we do on the way there.

Our hybrid approach includes making those choices in a disciplined, careful way based on all the available information that we have. This approach is more disciplined than just a “set it and forget it” type of an investment strategy.

In summary, when you look at the entire investing landscape, there are several strategies you could employ. If you are interested in taking a risk management approach, you may choose the active strategy, and consciously make decisions regarding your investments based upon market conditions. However, if you are just interested in following a market index, you would employ a passive approach. The third option available is a hybrid strategy whereby you would actively change which passive strategies are in your portfolio in order to change how much exposure you have in the market. Contact Us to find out more about our active overlay approach.

About Harvey Investment Management, Inc.

Harvey Investment Management, Inc. provides information designed to help our clients achieve their financial goals. We aim to empower and support investors no matter where they are in their financial journey. Reading this blog may be the first step of many you take, and we encourage you to ask questions along the way. We invite you to learn more about our team and how we can help you reach your financial goals by emailing or calling us at 719.960.0970.

Brad Harvey, President and CEO of Harvey Investment Management, Inc.