When deciding how to invest your money in order to maximize returns and minimize taxes over time, you may hear about two different strategies: active and passive investing. As the names suggest, active investing involves a more hands-on role for the portfolio manager, while a passive approach involves buying and holding investments for the long-term. Both strategies carry advantages and disadvantages, as well as tax implications that can have a significant impact on your bottom line.
Here is a brief overview of active versus passive investing:
What is active investing?
An active approach to investing aims to outperform the stock market’s average returns by frequently buying and selling investments—which may include stocks, bonds, mutual funds, exchange-traded funds, and other holdings—in order to take advantage of short-term price fluctuations. Since this approach requires specialized expertise and skill in order to have a reasonable chance of succeeding, active investing is usually handled by a portfolio manager and team of analysts. Active investing may offer the following benefits:
- Flexibility. Unlike passive investment managers, active managers are not required to hold specific assets, so they are free to choose those that they believe will yield a strong return. In addition, active managers can use strategies such as short sales and put options to protect against losses.
- The possibility of outperforming the market and delivering above-average returns.
- The ability to tailor the strategy to meet the investor’s specific goals, such as providing a targeted investment return or generating retirement income.
On the other hand, an active investment approach may carry the following disadvantages:
- High fees. Because active investing requires more research, specialized expertise, and hands-on management, the fees tend to be much higher than those associated with passive investing.
- Active risk. Since active managers have greater freedom in buying investments, this approach tends to be inherently riskier than passive investing.
What is passive investing?
Also known as index-style investing, a passive approach to investing seeks to limit buying and selling with a goal of avoiding fees and maximizing returns over the long term. Based on the belief that trying to outperform the market is difficult and generally not cost-effective, passive investing involves building a well-diversified portfolio and holding it for several years. A classic example of passive investing is buying an index fund that tracks one of the major indices, such as the Dow Jones or the S&P 500.
As the preferred strategy for the majority of investors, passive investing offers the following benefits:
- Low fees. Since passive investing doesn’t require handpicking stocks, it is much less expensive than active investing.
- Transparency. It’s easy to identify which assets are in an index fund.
- Simplicity. Unlike active investing, a passive approach does not require constant research and adjustment.
However, proponents of active investing point out the following limitations of a passive approach:
- Lack of flexibility. Regardless of market performance, passive investors are locked in to a specific index.
- Minor returns. Since passive funds are designed to track the market, it is very rare that they will outperform it.
Tax implications of active and passive investing
While active investing carries the possibility of greater returns, it also tends to generate a more substantial tax bill than passive investing. This is because when assets in a portfolio are bought and sold more frequently, gains on the sales are realized—which in turn triggers capital gains taxation. For assets held for more than 12 months, the capital gains tax rate ranges from zero to 20%, depending on your total taxable income. But for those held less than 12 months, you’ll have to pay short-term capital gains taxes at your regular income tax rate. This could be particularly costly for high-income investors. On the other hand, the lower turnover rate associated with passive investing means that you can defer payment of capital gains taxes for several years—and when you are taxed, it will likely be at a lower long-term capital gains tax rate.
Designing an investment strategy that will advance your financial goals and maximize your bottom line is a complex process, and some advisors recommend a combination of active and passive investing. Contact the financial experts at Tax Diversification today for assistance with determining which approach would work best for you!
–Stephanie Vance, J.D.
(Sources: https://executiveeducation.wharton.upenn.edu/thought-leadership/wharton-wealth-management-initiative/wmi-thought-leadership/active-vs-passive-investing-which-approach-offers-better-returns/, https://www.investopedia.com/news/active-vs-passive-investing/, https://money.usnews.com/investing/investing-101/articles/active-vs-passive-investing-which-to-use-and-when).
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