Should You Be an Active or Passive Investor? A Financial Adviser Breaks It All Down

A man sits at his desk and appears to be thinking about a problem.

Investing is one of the best ways to make your money grow. But if you're new to the game, it can be difficult to know where to start.

Factors like compound growth, outpacing inflation and the potential to build wealth are what attract most people to invest.

However, different investments carry varying levels of risk, and there are a couple of different strategies you can implement that align with your risk tolerance and future goals.

Kiplinger's Adviser Intel, formerly known as Building Wealth, is a curated network of trusted financial professionals who share expert insights on wealth building and preservation. Contributors, including fiduciary financial planners, wealth managers, CEOs and attorneys, provide actionable advice about retirement planning, estate planning, tax strategies and more. Experts are invited to contribute and do not pay to be included, so you can trust their advice is honest and valuable.

Which type of investor are you?

There are two main ways to approach investing:

• Active investing requires investors to make strategic decisions when buying or selling securities in an effort to outperform a market benchmark.
• Passive investing, on the other hand, aims to replicate the performance of a specific index, such as the S&P 500.

The approach you choose to take will affect how much you'll pay in fees, your level of involvement in portfolio decisions and the level of risk you're taking.

'Passive investing' is a bit of a misnomer

Generally, passive investing is considered safer for most investors because it relies on broad diversification while avoiding the risks associated with individual manager decisions.

While it may sound like passive investing doesn't require much effort, that's not the case. Passive investing requires thoughtful planning, such as selecting the right asset mix, rebalancing when needed and staying disciplined during market fluctuations, which can be tough.

Going active means taking more risk

Active investing is a bit different. Investors using this strategy are usually comfortable with taking more risk because they're trying to predict and beat the market — especially when they're relying on such factors as market timing, concentrated positions or intuition.

There are some active strategies designed to reduce risk, such as using derivatives or funds that move against the market to mitigate losses. Tactical asset allocation and rebalancing your portfolio as necessary can also help reduce your risk.

Which style suits you better?

Choosing between active and passive investment strategies really depends on you. What are your goals? What is your timeline and risk tolerance and how do you feel about market efficiency?

Looking for expert tips to grow and preserve your wealth? Sign up for Adviser Intel (formerly known as Building Wealth), our free, twice-weekly newsletter.

Passive investing works well for those who are new to investing, looking for broad diversification, are approaching retirement or looking to preserve capital and reduce volatility.

However, active investment strategies are more attractive to investors who are hoping for higher returns in targeted areas.

A strategic blend could be best

If you find yourself somewhere in the middle, a blended portfolio that utilizes both strategies can be quite beneficial.

This approach gives you the ability to manage risk, increase opportunities for growth and expand diversification. Your passive investments offer lower costs and diversification, while the active investments can provide opportunities that add value to your portfolio or manage risk in specific areas of the market.

The bottom line

What's important is maintaining a clear strategy, avoiding overlapping exposures and making adjustments as needed.

Entering the world of investing can be an exciting journey. It provides you with an opportunity to maximize your earnings, build wealth, achieve financial goals and provide you with stability and security in retirement.

With that being said, if you don't know or understand what you're doing, your finances could take a serious hit.

To get started, consider meeting with a financial adviser who can help you assess your risk tolerance, provide guidance on investments that may be a good fit and help you rebalance or adjust your portfolio as your life changes.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.