The Difference Between Active And Passive Investing

By Matthew Amster-Burton | April 27, 2012 AAA

Once a month, I meet up with some smart people in my neighborhood to drink coffee and try to stave off mental decline by talking about hard financial topics: macroeconomics, taxation and sometimes even something useful, like investing. It's like Facebook chat, only you can smell the other participants.


I'm not going to get into the passive vs. active debate in this column. I just want to see if I can figure out what we're talking about before I wade into that debate in the near future.

"What is passive investing?" may seem like an arcane question that nobody but latte-fueled intellectuals should care about. On the contrary, pal: if you're saving money for the future, deciding whether to take an active or passive approach is among the most important decisions you'll make.

Who's Active?


Market timing. Markets gyrate. If you can correctly predict those gyrations ahead of time, you can make a lot of money - or avoid losing it.



Who's Passive?
With that definition in mind, let's cook up a couple of hypothetical investors and see who's passive and who's active. (Aren't these terms a little judgmental, by the way? That's why MintLife columnist Dan Solin likes to refer to passive investing as "smart investing.") This is my column, so I get to be the judge and jury. We'll start out easy.

Verdict: Active.


Verdict: Active.

Charlie buys mutual funds, holds them and never trades. However, his mutual funds are actively managed, so the fund manager may be trading stocks within Charlie's funds.

Verdict: Active.

Donna buys diversified index funds or ETFs, holds them and never trades.

Verdict: Passive.

Rick Ferri, in his book "The Power of Passive Investing," puts these four investors into a handy chart, which I'm going to simplify and reproduce here.

Uses actively managed funds or individual stocks Uses index funds or ETFs
Trades Alice Bob
Doesn\'t trade Charlie Donna

As you can see, only Donna meets Ferri's (and my) definition of passive investing.

The Hard Cases
Now, let's ask some tougher questions.

Verdict: Not enough information.

If Emily has chosen a 50/50 portfolio because it's in line with her risk tolerance, she's passive. If she believes this portfolio looks like a winner for the moment, but intends to change it later when stocks look like a better bet, she's active.

Frank owns only index funds and ETFs in a 50/50 stock/bond portfolio, but he trades once a year or more to bring his portfolio back in line with its original allocation. That is, if bonds go up and stocks go down, he sells off some bonds to buy more stocks until he's back to 50/50. This is called rebalancing.

Verdict: Passive.

Rebalancing is about keeping your portfolio risk under control; it's not about trying to time the market.


Verdict: Passive.



Verdict: Hmmm.

I'm not sure. It smells like market timing, but is it?

Get Your Team Alice T-Shirts Here
Alice, our pure active investor, works hard at investing. She is up on the latest IPOs, valuations, interest rates and market trends. She has a whole folder of investing apps on her phone.

Meanwhile, Frank, our passive buy/hold/rebalance guy, doesn't know anything about any of that stuff, and he spends a few minutes a year managing his portfolio.

You can probably guess whose team I'm on, but let's talk about you: are you an Alice or a Frank, or someone else from our cast of characters? And why?

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