Consider a scenario: two friends, Anish and Mohit, embark on a financial journey of trading and investments. While Anish is keener on studying the markets, analysing stocks and following news and trends to make quicker profits, Mohit opts for a steady, diversified and low-maintenance approach to achieve his goals.
They both, hence opt for different approaches or trading accounts to earn profits.
In the below article, we shall explore the key differences between active and passive strategies to understand which approach can suit you the best.
What is an Active Trading Account?
Active trading is more about a “hands-on” approach, meaning it involves buying and selling investments quickly to take advantage of short-term price fluctuations. You will be called an active investor or trader if you hold your investments for a shorter period.
Since, in this approach, you are focused on generating profits from price fluctuations, you must have a good understanding of when to purchase or sell a particular stock, bond or asset. Statistical and technical analysis, current news, economic events and earnings play a vital role in anticipating short-term price movements.
Common types of active strategies:
- Day trading
- Swing trading
- Scalping
Pros and Cons of Active Trading
Pros:
- Active trading account managers have flexibility in investment.
- As an active trader, you can capitalise on the opportunities arising from price fluctuations to generate higher returns.
- Active traders are taxed on their business income, unlike investors who are taxed on capital gains.
Cons:
- There is a high level of risk involved.
- Active trading requires a certain level of time commitment, which may not be possible for everyone.
- Without adequate knowledge and skills, it can be challenging to earn profits.
What is a Passive Trading Account?
As the name suggests, passive trading accounts follow a more relaxed way of investment, wherein you buy financial assets and hold them for a longer period of time.
Also known as the buy and hold strategy, many times, passive trading account holders create an investment portfolio that replicates the composition as an underlying index (for example, Nifty 50) and holds them for the long term with minimum trade in stocks.
Alternatively, they may do their research and pick good stocks that they can hold for long.
This strategy involves resisting the temptation to anticipate price fluctuations, instead having a long-term approach to investments.
Common types of passive strategies:
- Index funds
- Exchange Traded Funds (ETFs)
- Buy and hold strategy
- Target-date funds
Pros and Cons of Passive Trading
Pros:
- Reduced trading volumes result in lower costs.
- When investing through passive strategies, you invest in more stable and diversified funds, thereby reducing risks.
- You are aware of the assets you own.
- It is easy to understand and manage.
Cons:
- You may match market returns but not outperform them. Hence, returns may be lower than actively managed investments.
- There is a lack of flexibility as most of the passively managed investments must stick to their underlying index or strategy.
- There can be a risk of overexposure to a certain sector or industry.
Factors to Consider When Choosing Between Active and Passive Trading
If you wish to trade in stocks or any other financial instruments, it is important to open a trading account and choose between active and passive investment strategies. The below factors can help you make an informed decision.
- Past performance: Although you cannot base your investment decision solely on past performance, having a good idea about the historical performance of an investment can help you in a big way.
- Costs involved in investment: Since the active investment approach requires the active participation of the investor, the cost involved is also higher.
- Ability to customise the portfolio: If you have a good understanding of the market and would like to customise or make your investment decisions yourself, an active investment strategy allows you to do that.
- Ability to diversify: With an active investment strategy, you can opt for diversification of funds, leading to higher returns.
Conclusion
Both active and passive strategies have their pros and cons. Choosing the right trading account is imperative as it depends on your circumstances and goals. You can always blend and create strategies that suit your risk appetite and help you achieve your financial goals.
