The Difference Between Active and Passive Investment

Investments should be made early, so that financial independence in the future can be achieved in a structured and planned manner. Investing does not have to wait old. Even if you are young but have adequate financial capabilities, there is nothing wrong with investing.

In principle, investment is utilizing the funds or capital owned to be placed in another business activity that aims to obtain passive income or additional income. Therefore, the main requirement for investing is ownership of funds or capital.

There are many types of investments to choose from. Call it stocks, bonds, certificates of deposit, mutual funds, and so forth. However, before deciding to place your capital in one type of investment, it is better if you know the investment strategy used.

Talking about investment strategies, there are two strategies that are commonly used, namely active and passive investment. Both of these investment strategies are more directed at the approach or method used in managing investment funds.

Definition of active investment and passive investment

• Active investment

Active investment is an investment strategy that uses a direct approach that requires investors to act as a portfolio manager. The main goal of this active investment strategy is to beat the average return on the stock market and take advantage of short-term price fluctuations to achieve full profit.

An active investment strategy requires the ability to analyze in depth and the expertise to know the right time to buy or dispose of assets, whether in the form of stocks, bonds or something else. As an investment fund manager, a portfolio manager performs the oversight function of his team of analysts in view of qualitative and quantitative factors. Not only that, the portfolio manager also determines when and where prices will change.

In an active investment strategy approach, investors must have confidence and the ability to see market situations and changes so they can know the right time to buy or sell assets in the form of securities. Therefore, a successful active investment manager must be able to make correct and correct decisions and minimize mistakes.

As the name implies, this active investment strategy is very aggressive. Portfolio managers from this strategic approach will get information and input from their team of analysts who each specialize in different sectors. This strategy specifically records the value, growth, profitability, and yield characteristics of a stock. All parties involved, both investors and portfolio managers and their team of analysts will study the competitive environment and markets that are the target of the company's operations. Not only that, macroeconomic factors that can affect the company can not be separated from his monitoring.

The approaches used to achieve these active investment goals are often difficult to measure or validate with empirical evidence. Therefore, active investment strategies are more often associated with key individuals. That is, investors tend to trust portfolio managers who have a good reputation and good performance, compared to the process or approach used.

Investment funds that are actively managed can generally be divided into three. First, actively managed mutual funds are marketed to retail investors. Second, segregated funds marketed to individuals with multiple assets and small institutions. Third, pension funds in large institutions that employ active managers to manage internal funds.

• Passive investment

Passive investment is an investment strategy that is implemented by limiting the amount of fund turnover. This strategy is suitable for investors who want to invest in the long term. Passive investors will limit the amount of buying and selling in their portfolio. Although it looks simple, this strategy requires a strong mentality in buying and holding a portfolio. That is, investors must be able to resist the temptation to react to market situations and changes that affect the stock market.

An example of a passive approach to investing is buying index mutual funds that follow one of the main indexes, such as the IDX30 or LQ45. Whenever there is a change in constituents, index mutual funds will automatically follow suit by selling outgoing stocks and buying stocks that are part of the index.

As a passive investor, if you own thousands of shares of small value stock, you will only get your return by participating in the company's upward trajectory over time through the stock market as a whole. A successful passive investor will pay more attention to long-term gains than losses or even sharp declines in the short term.

Funds that are managed passively are called index funds. While the first index fund is a mutual fund. Passive investment strategies depend on the reputation or performance of the stock itself. When in an index there are stocks that have good performance, their weight in investment will grow. Conversely, if the stock performance is bad, it will have an impact on decreasing investment performance.

 

The difference between active investment and passive investment

From the name it is clear that active investment is different from passive investment. This difference is of course not only from the term, but also the purpose and approach. In principle, the difference between active investment and passive investment can be seen from the strengths and weaknesses of each investment strategy.

Based on the strengths and weaknesses of active and passive investment, the differences between the two are shown in the following aspects.

• Flexibility

From the aspect of flexibility in investing, active investment tends to be more flexible than passive investment. Investors or active portfolio managers have discretion in investing. That is, in an active investment strategy, investors or portfolio managers are not limited in their movement to follow certain indexes. They can buy and release shares at any time freely. As long as they believe that a stock is experiencing growth and has good performance, then they are free to buy the stock. Related to this, active investment involves a variety of strategies or approaches ranging from derivatives, hedging, leverage, arbitrage, and so on.

Another case with a passive investment strategy. Passive investment flexibility tends to be low. This is because passive investment strategies are limited to certain indexes or a predetermined set of investments. This investment strategy involves buying and selling based on changes in the composition of the index. It is not surprising that passive investment strategies often experience market volatility due to the limited use of the strategy. Passive investors are trapped in long-term portfolio ownership, so they are not reactive to all changes that occur in the market.

• Investment protection

Investment protection is also known as hedging, which is a strategy to limit or protect investment funds from fluctuations in currency exchange rates that are considered unprofitable. As a strategy, hedging provides an opportunity for investors or portfolio managers to protect capital from possible losses even when transactions are in progress.

In terms of investment protection or hedging, active investment tends to be more protective than passive investment. An active investor or manager can hedge their investment using various techniques such as short selling or put options. In addition, they can also exit certain stocks or sectors that are known to have too much risk.

While passive investment is not the case. Passive investment protection tends to be low, because passive investors or managers are trapped in stocks that are tracked by an index, without considering or evaluating their performance.

• Rate of return

From the aspect of rate of return, active investment is higher than passive investment. The main goal of active investing is to beat the market, so it focuses on absolute returns. With strategy flexibility, active investors or managers can earn high returns.

Passive investment has a low or small rate of return. This is influenced by the passive investment objective, which is to adjust to market performance or a tracked index. That is, passive investing will never beat the market, because ownership is locked from tracking the market. While passive investing can sometimes beat the market, it never yields the large returns active investors or managers would like.

• Tax management

One thing that is the goal in investing is to get capital gains or what is called capital gains. Capital gains are profits earned in investing, where capital assets have a selling price that is higher than the purchase price.

An active investment strategy has the potential to earn high returns. This can also trigger capital gains taxes. Nonetheless, active investors or managers can adjust tax management strategies, for example by selling investments that are at risk of loss or do not experience growth as a result of poor performance. This step can be done to offset taxes.

In contrast to passive investment. In this investment strategy it can actually achieve tax efficiency, because the buy and hold strategy not to release or sell shares generally does not generate capital gains tax.

•  Operating costs

Active investment strategy creates high or expensive operational costs. This is due to the activity of buying and selling securities actively triggering transaction costs. Not only that, active investment also bears the burden of costs in the form of wages or salaries of the team of analysts who conduct research and select equity. The high cost of this investment actually risks eroding the level of profit or return.

Meanwhile, passive investment strategies tend to be low-cost in operation. This is because in implementing this investment strategy there is no team of analysts working to analyze and evaluate the movement of securities, so the monitoring costs are much cheaper. In its operations, passive investment is only sufficient to follow the index used as a benchmark.

• Transaction frequency

The activity of buying and selling securities in active investment is clearly more frequent than passive investment. Therefore, the frequency of transactions in active investment is higher than passive investment. The shift in preference to passive investment is based on a change in the composition of the index.

• Investment term

Active investment targets market performance to beat. That is, active investment operates on the basis of stock market movements. Active investors or managers cannot be separated from market mechanisms, so they need information related to market conditions and changes at any time. Due to market conditions that are constantly changing, active investors tend to take advantage of short-term price fluctuations. These fluctuating prices greatly affect the rate of return and also the decision to buy or release securities in active investment.

Unlike the case with passive investments that ignore short-term fluctuations. Passive investment activity is more emphasized on long-term investments. Therefore, passive investors or managers tend not to work too much, because they are only based on the index. In addition, passive investing is not too affected by movements or changes in the stock market.

• Skills required

In order for an active investment strategy to be able to achieve the target and generate the expected high rate of return, adequate skills and expertise are needed in analyzing the stock market. Starting from price movements to making the right decision to buy profitable securities or release securities that are at risk of causing losses. To play into active investing, investors or portfolio managers must have superior skills in identifying price discrepancies, arbitrage opportunities, fundamental or technical assessments of stocks, and so on. With these skills, active investors or managers can make the right decisions when to buy or sell shares.

Not as complicated as active investment, implementing a passive investment strategy does not require deep skills and expertise on how to invest. In fact, novice investors who are inexperienced and do not have basic knowledge in the investment field can play it. In a passive investment strategy, generally only a few decisions are made, and that is done by an investment manager.