Active vs. Passive Stock Investing

Passive stock investing is the strategy of buying stocks and hanging on to them. In contrast, active stock investing involves buying and selling stocks on a regular basis.

Whether you choose an active or passive strategy, investing in stocks requires an honest self-assessment. Ask yourself:

What do you want from your investments? How much attention will you pay them? How good is your judgment? What's your tolerance for risk? Your answers will help you determine which type of strategy will work best for you.

Passive investing relies on the fact that over time the market has always gone up. If you're not passionately interested in the stock market and you're investing mainly for retirement, a passive strategy may be your best bet.

Passive investing can deliver a decent return in the long run with a minimum of involvement. Two things are critical to this strategy:

Choose stocks that have good potential to increase steadily in value over the term of your investment. Select a diversified portfolio, so you're not tied to the fate of one particular company or market sector. Consider adding instruments such as bonds, which tend to go up in value when stocks are going down, as a hedge. Although passive investors regard short-term fluctuations in stock prices as minor compared to long-term growth, they still can't just pick a portfolio and forget about it. Even passive investors should reevaluate the performance of their stocks periodically and respond to long-term market changes.

If you want a passive strategy that demands relatively little attention, consider index funds -- funds weighted to mirror a major stock index like the . Over time, index funds have usually done better than individual stocks. Investing in index funds to ride the market can be a great passive strategy, as long as you have the time to ride out market dips.

Active investing takes advantage of those short-term fluctuations in the market. Pursuing an active approach takes a lot more time and involves more risk. Most active traders check on the prices of their stocks several times each day!

Active traders hope to "outperform the market" by exploiting minor ups and downs -- picking up stocks that are experiencing temporary drops in value at reduced prices, and selling them when they're on their way up again.

While they can often realize impressive gains with well-timed purchases and sales, success depends on good judgment, sound information, and sometimes luck. Active investing can feel a lot more like gambling, where quick decisions can have major consequences. If your reason is often overwhelmed by your emotions, active investing probably won't work well for you.

Be honest with yourself about your powers of discernment. Remember, 74 percent of the drivers in a 2002 poll considered their own driving skills better than average -- it's easier to convince yourself that you can beat the market than it is to beat it in practice. Before you invest any real money, you may want to test your judgment by picking some stocks to follow and making decisions on when to buy and sell as if you owned them.

Since every trade incurs brokerage and transaction fees, active investing costs more money than the passive version. Many active traders also make use of margin arrangements -- borrowing money to buy stock in the expectation that profits from the future sale of the stock will pay back the loan. If the stock doesn't appreciate as expected, buying on margin can be an expensive mistake.

But if you're consumed by the markets, comfortable with a high level of risk, and confident in your own judgment, active trading can result in higher gains sooner than a passive strategy. Just don't overlook that level of risk -- active investing can produce higher losses just as fast.

Whether you choose an active or a passive approach to your portfolio, be sure to do your homework on any stock or fund you plan to purchase. They key to successful investing is to make the best choices. You can only do that if you take the time to know what you're buying.