Active or passive investing?

Short term trading or long term holding

Active investing entails short term buy and sell operations,
nearly as frequent as in market trading.

They are done either on the basis of trend following,
or on the contrary by grasping market anomaly opportunities.

Passive investing or "buy and hold" is choosing assets for the
long term, either through diversification or via highly selective
asset picking.

Both methods have their positive and negative incidence.

sous buysell Hare trader or tortoise investor?

Definitions

1) Active investing - or active (portfolio) management

Never at rest.

Active investing is a money management method based on frequent short
term
operations that verge on intensive trading / short term speculation.

Those frequent "arbitrages" (*) are usually based, everybody its own taste,
on two opposite submethods:
so as to take advantage of price or return distortasymm discrepancies
that the market would, in theory, correct sooner or later.


As this entails trading costs, and competes with trading robots /
software that use fast communications lines (that might create
other deviations), rather do it wisely, playing preferably on what
looks like sizable distortions, hoping they will revert and at least
not enlarge.
  • Or on the contrary playing market price drive momentums
by following (trend following) the direction of those distortions,
betting on their persistence and their increase.

Kneeling and praying in the hope of not being the last fool who
ride them just before they revert.

(*) An arbitrage is to sell an asset and buy another one (or the same 
     
one), immediately or in a short time period)

2) Passive investing - or passive management

Choosing the right horses, and letting them run

Passive investing is a long term money management strategy, also
called "buy and hold".
It is done with as few as possible buy and sell operations.
No wild orders!


Those scarce adjustments play essentially on decisive changes in
the fundamental prospects of the assets held in the investment
portfolio.

Passive investors might be either highly selective or on the
contrary aiming at a
diversified portfolio.

This supposes (see below)
  • Either to choose selectively specific assets
on the basis of their long term prospect and visibility (**).
  • Or to prefer index investing on a class of assets
(stocks usually, as detailed in a specific section below),
seeing  the market as efficient enough to balance well
performing and badly performing assets.
  • Or to have a fully diversified portfolio
with all kinds of assets, considering that their price and
return evolutions are (usually at least) not correlated

(**) Selective investors, called "stock pickers" if we take stock
       
investment as an example, choose typically:
(stocks from firms with stable and reliable past records
and with  low prices  when compared for example to the
firms' earnings)
(they are more expensive in comparison of the firms' present
results but are considered to have the prospect of a fast rise
of those results, usually in reference to past growth record),

Advantages and drawbacks

1) Active run investing

Active investing
- has the advantage of adapting the asset portfolio to market situations.
- but can become highly risky and costly if it leads to:

* Overtrading.
   Here we have "hyperactive" more than just active investing
   This is usually based on "noise trading" : taking any small

   market move
as a signal on which to bet.

* Concentration of assets (selectivity) instead of diversification. 
   Although the idea is usually to "beat the index"
   many actively managed portfolio tend actually to
underperform it.

2) Passiveeconsector  investing

Passive investing is normally well adapted for investors with a long
term horizon
(for example to build a nest egg for retirement).

It minimizes transaction costs and impulsive decisions..

But when it becomes resistance to change (conservatism bias,
status quo bias)
it has its risks also.
For example it is usually financially dangerous to keep an
asset which we mentally overvalue
just because we own it
(endowment bias), or just because its price fell (loss aversion).

Another thing is that
* uptrends in some classes of assets can suddenly fall from the
   cliff
* downtrends in some classes of assets can last for a very long
   time.
=>
Thus passive investing does not exclude
some tactical
        and strategical "reallocations" or "rebalancing":
* plancalend Periodic reassessments and fine tuning (i.e. once
   or twice a year),

* And, in case of major foreseeable evolutions, a more
  
drastic reshuffle of assets within the portfolio, to rebalance
   and adapt it, or
to radically shrink or expand it.

3) What about index investing?

As mentioned briefly above, one form of passive investing is "index
investing".

This is putting money in a fund which portfolio tries to evolve as
an official stock index, but with the disadvantage of being subject
to stock cycles if there is no diversification in other assets.


Actually indexes do not offer perfect / efficient diversification,
thus some portfolio managers use various techniques, under the
generic label of "smart beta" to correct them and offer better
references.


Also, management fees that tend to eat dividends, something not
too visible as indexes do not take them into account.

So there is some illusion for the holder to believe its performance
mirrors a known index, while not realizing that he/she loses what
shareholding is basically made for: to share in corporate profits by
getting dividends
.

Corporate and economic incidences

Positive and negative incidences
of active
trading

Active trading brings market liquidity.

It brings also market reactivity to economic condition.
Therefore when done on the stock market, it puts some pressure on
corporate executives to adapt and improve the operations of their
firms.

On the other hand it can also bring mispricings because of trend-
following, that might entice the management to perform inadequate
actions.

Also, In extreme cases, when all active traders (or their computers
doing "algorithm trading") react at the same time, it could, instead of
bolstering market liquidity, bring a liquidity crisis

Positive and negative incidences
of long term investing

Long term investing brings shareholder stability which i, its turn
favors corporate long term strategy, together with more direct
participation by those shareholders (at least the most important
ones) into the corporate governance.

On the other hand it can bring some corporate management
complacency
.

Reference and further reading

See in this site (the Behavioral finance glossary section)
details about
Investor styles, time preferences and
noise trading
And also some principles of
stock portfolio management.

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M.a.j. / updated :04 Sep. 2015
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