Maybe you’re interested in learning more about the stock market. Perhaps you’re the kind of person who is willing to take a chance if it means a shot at beating the odds.
Or maybe you trust yourself or a professional to have the smarts to predict which stocks are likely to do well. If any of these are the case, you may be interested in giving active investing a try.
Active investing can sound scary, but it doesn’t have to be intimidating. The active investment strategy definition is pretty straightforward: The term refers to trading individual stocks or bonds in an attempt to beat the ‘market’.
You could be the one making these choices, or you could invest in mutual funds where managers actively make those decisions.
The alternative is passive investing, where you put your money in a group of stocks, such as an index fund or exchange-traded fund (ETF), and mostly sit back.
Active investing has grown less popular in recent decades, as passive investing has been on the rise. Since the first index fund—the S&P 500—launched in 1977, hundreds have followed.
In 2007, passive funds accounted for 20% of equity assets under management. In the decade since, that share has doubled, according to data from Morningstar.
While active investing has become less widespread, it’s still worth exploring. Here’s a guide the pros and cons of adopting an active investment strategy:
The Advantages of Active Investing
Active investing has its perks. If you are in the driver’s seat when it comes to buying and selling stock, it’s one way to build your investing chops. Rather than setting and forgetting, you can research individual companies, sectors, and geographies and put that knowledge to work by placing your bets.
It can be both fascinating and rewarding to invest in specific companies you know and believe in, especially if they align with your interests or social values. It can also be exciting to put your skills to the test and see if they get rewarded. Being in control can give you a thrill that some compare to gambling.
Another pro of active investing is the possibility of potentially outperforming the market. If you are passively investing in funds that mirror the market as a whole, such as the S&P 500, you can only do as well as the market performs.
And if there’s a major downturn, you are likely to see your losses reflect that directly as well. If you or a fund manager put your expertise to use and happen to pick stocks that do very well, there is a chance you can earn higher returns than you would otherwise.
It should be noted, though, that most active investors, including active mutual funds, have historically had a difficult time of beating the market, especially after factoring in fees and taxes paid.
Active investing also allows you to put in place a strategy that’s tailored to your preferences, goals, and risk tolerance.
Whether you’re willing to be speculative because you’re young, prefer to support companies that align with your values, or want a mix of stocks that you personally think are the most likely to do well, active investing allows you to build a completely customized portfolio.
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Cons of the Active Approach
While active investing has its upside, it also comes with risks and disadvantages. Importantly, although an active strategy has the possibility of beating passive funds when it comes to returns, the likelihood of that happening is very low.
Between 2002 and 2017, actively managed funds produced returns that lagged behind 92% to 95% of index funds, depending on the type of fund, according to Standard & Poor’s.
That meant that the odds of an actively managed fund outperforming an index fund were about one in 20. And that’s when professional fund managers are the ones picking stocks!
The reality is that no one can precisely predict the direction of the market or an individual stock’s performance in the short term. The confusion has only amplified as the volume and speed of trading has increased dramatically.
Active investing can be challenging, and there is a real risk that you will earn lower returns than you would with the passive approach.
Another downside of active investing is that it takes time. Having a chance at success as an active investor means doing a lot of research on companies and market conditions, keeping tabs on news that could affect performance, and making decisions about whether to buy or sell.
The amount of information out there and the speed with which it’s transmitted is only growing. You probably have many other competing priorities. Unless investing is a passion of yours, the active approach may not be worth the time needed in order to reach the same or better results.
Another drawback of active investing is that it can encourage you to focus on the short term rather than the long term. Whereas passive investors typically look at the long-term potential of their holdings, many active investment strategies are focused on near-term gains, whether that be a matter of months or even minutes.
If you get lucky, that short-term focus has the potential to lead to quick profits. But more often, it also creates more opportunity for losses.
A short-term focus also usually means buying and selling stock more often. Trading frequently often comes with added costs, from the fees that you pay to trade to the adverse tax impacts, such as capital gains taxes.
If you’re saving for goals that are years away, such as retirement, or just prefer less risk and lower fees, you may want to think twice before adopting an active approach.
How to Get Started with Active Investing
If you want to pick your own stocks, it may be wise to prepare for a learning process. At a basic level, that could mean putting together a portfolio of 12 to 20 individual stocks.
That’s low enough that tracking the companies regularly is plausible but also allows for some diversification within the portfolio. Sometimes, it can be worth choosing to investing in companies that you have a solid understanding of, including how they make money and the risks they face.
Another way to add some diversification is to divide the investments in a portfolio across different industries and sectors, rather than sticking to a narrow mix.
If you are starting out on a limited budget and can’t purchase that many individual stocks, you might want to try buying fewer while balancing them with mutual or exchange-traded funds that have more diversified return streams.
When you’re going with a professional manager, it’s a good idea to vet him or her. Take a look at how long he or she has led the fund and review the fund’s performance over at least five years. That can help you evaluate returns in different market cycles.
Also consider the costs: Funds with lower expense ratios have a better chance of beating indices because a smaller share of the returns are getting eaten up. Looking for a fund that is tax-efficient can also be a good idea.
Some people suggest identifying managers who themselves invest in the fund, which ties their self-interest with those of investors.
Remember that deciding between active and passive investing doesn’t have to be an all-or-nothing deal. You could opt to invest some of your holdings in passive funds or with an automated investment tool, while setting aside another portion to invest more actively.
Investing with SoFi
If you’d like to dip your toes into active investing, opening an account with SoFi Invest® can be a good way to get started. There are no account minimums, meaning you can learn and grow as an investor without putting a lot on the line.
The platform makes it easy to track performance and stay up to date with the latest news.
And you’ll be able to buy and sell stock without paying any fees or commissions to SoFi. You can choose to invest in companies that you know and believe in or find new possibilities curated based on your interests.
Since active investing isn’t for everyone, you can also take the automated investing approach by having SoFi create and manage your portfolio, without paying a management fee. SoFi can help you identify your goals.
With a SoFi Invest account, your portfolio will be automatically adjust on a quarterly basis to make sure it’s on track with your goals and risk tolerance.
Whether you’re taking the active approach or sitting back, investing with SoFi also gets you member benefits, such as access to exclusive events, discounts on other financial products, and complimentary time with licensed financial advisors. You can set up an account online in just two minutes. Whether you want to take the reins or go the automated route, it’s easy to put your money to work with SoFi Invest.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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