Behavioral finance FAQ / Glossary (Active-Passive)
This is a separate page of the A and P-Q sections of the Glossary
Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
Active / passive (investing / management)
07/8d + See momentum trading,
overtrading, speculation, buy
and hold, style, time horizon
Buzzybee vs. Hibernatus
Speed race vs. Marathon
Active investing - or active (portfolio) management -
is a type of money management based on
short term operations with :
* Frequent arbitrages (see that word) to adapt the portfolio
to new information affecting fundamental prospects.
* And/or momentum trading (see trend following).
It tends also to imply an intensive use of derivative financial contracts
(futures, options, CFD / contracts for difference...).
Passive investing - or passive management -
is a long term money management mode, with as few as
possible buy and sell operations.
It is also called "buy and hold" (see that phrase).
But it cannot be fully inactive, some "reallocation" might be done such as
* Periodic reassessments and fine tuning (i.e. one or twice a year),
* More drastic asset reshuffles in case of major foreseeable
evolutions, to rebalance and adapt the portfolio, even to radically
shrink or expand it.
A mode of passive indexing is "index investing", that reproduces the
evolution of a stock index. But 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
Relation with investor styles
Active or passive investing is a key aspect of an
investor style (see style)
The differences are linked to the investor's:
* time horizons,
* risk attitudes,
* anticipation abilities and methods.
Those are highly personal traits that might be compared, sorry if
you find it outrageous, hope we stay good friends, to individual
tastes in arts or in the choice of a profession.
Even if those human traits are in no way perverse, some ideological circles
label depreciatively - if not hatefully - their applications to
* Speculation (see that word), for active management
(but speculation is actually risk taking and anticipation, what makes human
beings different from lettuces)
* Hoarding, for passive management.
(or "making money while you sleep", but why not if you invested time
and money in the first place?)
Consequences for the investor
Active: adaptation or overtrading?
Passive: Zen management or status quo bias?
Active investing has the advantageto adapt the portfolio
to ever changing perceived market situations.
== But it can become highly risky and costly if it leads to
noise trading / overtrading / (see those words) and
an over-concentration of assets instead of diversification.
Passive investing minimizes transaction costs and
== But if it reaches extremes (see status
quo bias) it hinders adaptation to decisive evolutions and it
has its risks also.
For example there is usually a financial danger to keep an asset
which value we overestimate just because we own it (see
"endowment bias"), or because its price fell (see loss aversion).
One form of passive investing is "index investing".
It has the disadvantage to be subject to stock cycles if there is
no diversification in other assets.
Consequences for the market
Hard to find the right speed.
A balance between those two different practices and
time horizons would help market efficiency.
The car speed has to adapt to traffic conditions.
But this balance is far from being always reached.
Market distortions, and in extreme cases market
illiquidity, might happen when everybody
plays only on:
Either a short term basis (and with the same expectations),
Or a long term horizon.
This might show a denial that long term economic projections are
uncertain and a collective dependence of investors to the same
expectations ...or in some cases to gurus.
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