The world of investing can seem like a pretty daunting place for the uninitiated. It is a highly specialised area of finance with its own rules, its own technical language, its own customs and culture, all of which combine to make it difficult to fathom for the average layperson.
One of the things anyone new to investment has to get to grips with is differences in investment strategies. A lot of the advice you will get about investing your money is couched in terms like active or passive, or in more recent times, pursuing an evidence-based approach. You’ll be asked about your risk tolerance, advised about diversification, and shown how rates of return vary depending on the strategy you choose.
But what do all of these terms mean? In this article, we’ll unpick those three main approaches to investment strategy – active, passive and evidence-based.
Active investment
Active investing is the type of activity associated with stock brokers and the high-octane world of floor trading. It’s all about buying and selling assets with a view to beating average returns in the market, which requires a very hands-on or ‘active’ approach. In short, the goal is to buy when stakes are cheap and then sell when prices hit a peak. Active investment can result in high returns, fast, but the risks are often high.
Passive investment
Passive investing is often characterised as a long-term, conservative, “buy-and-hold” approach that seeks to limit risk. Unlike active strategies, which look to capitalise on fluctuations in the market opportunistically, passive investments play the long game, leaving assets untouched often for decades at a time on the principle that markets in general tend to grow. Passive investment is also closely associated with diversification, or spreading assets around different markets to further mitigate risk.
A typical example of passive investment is what is known as an index fund, which uses financial market indices as the foundation for compiling an investment portfolio. An index fund would look at a particular stock market, for example, and purchase stakes in the companies listed, weighing assets according to the position of individual organisations. The specific companies invested in might change over time as they come and go from the index, but the strategy is built around providing stable, predictable returns over time.
Passive investment is usually used as the core strategy for long-term vehicles such as pension funds.
Evidence-based investment
Like passive, evidence-based investing takes a long-term view, it is systematic in its approach and it is founded on the principle that the market always wins out. Yet it also includes some more ‘active’ elements, and can perhaps best be understood as a third way which synthesises the strengths of both passive and active strategies.
Unlike the kind of passive approaches demonstrated by index funds, evidence-based strategies are not content to just ride along with the market and accept what it deals out regardless. Instead, evidence-based investing aims to understand the deeper reasons why markets tend to deliver growth in the long term (and what causes the exceptions when they don’t). Armed with the insights of academic research into market mechanics, fund managers who take an evidence-based approach will then aim to build portfolios which follow defined rules for market growth, without simply trusting that the fluctuations in the market will go your way.
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