Wednesday, June 8, 2011

The Many Definitions of Active and Passive Investors

A post over at Boomer & Echo made me realize that the terms “active” and “passive” have multiple definitions when it comes to investing. This can lead to confusion.

The most technical definition of active/passive relates to investor goals for returns:

Defintion 1.

Active Investor: One who seeks to outperform the market averages. This is usually done by either attempting to make better short-term trades or by trying to choose better stocks for the long term. Most active investors fail to beat the market, but each year some succeed.

Passive Investor: One who chooses to own one or more indexes of stocks, bonds, or other assets. This type of investor usually seeks to minimize costs to get returns as close as possible to market averages.


Another definition relates to how frequently an investor makes trades.

Definition 2.


Active Investor: One who makes frequent equity trades.

Passive Investor: One who trades equities infrequently.


A third definition relates to how involved an investor is in the business of investing his or her money.

Definition 3.

Active Investor: One who takes a do-it-yourself approach with investing.

Passive Investor: One who hands control of his or her investments to a professional.

I am now a passive investor in the sense that I invest in broad indexes, and passive in the sense that I trade infrequently, but I’m active in the do-it-yourself sense. Warren Buffett is active in terms of stock picking and handling his own investments, but is passive in the sense of trading infrequently.

It would be nice to have everyone agree to use different terms for all these definitions, but I’m not holding my breath.

11 comments:

  1. Yes, I can see the confusion as the terms aren't completely exclusive, but in my experience active vs passive almost always refers to definition 1.

    For definition 2 terms like "trader" or "buy & hold" are used more often than active/passive, and I don't think I've ever heard active/passive used in the definition 3 sense.

    ReplyDelete
  2. @Potato: I tend to use Definition 1 as well, but this is unlikely what the average person would think that "active" and "passive" mean in connection with investing. Definition 3 seems to be roughly what was used in the Boomer & Echo post I pointed to at the beginning of the article.

    ReplyDelete
  3. Hi Michael, thanks for the link. There is a lot of confusion surrounding these terms. Here is the definition of passive investing from the esteemed site, Investopedia:

    What Does Passive Investing Mean?

    An investment strategy involving limited ongoing buying and selling actions. Passive investors will purchase investments with the intention of long-term appreciation and limited maintenance.

    Unlike active investors, passive investors buy a security and typically don't actively attempt to profit from short-term price fluctuations. Passive investors instead rely on their belief that in the long term the investment will be profitable.

    I think you are correct to assume the average person believes that passive investing means limited trading, while active investing means to try and profit short term by frequently trading.

    ReplyDelete
  4. A comment from Echo seemse to have become lost:

    Hi Michael, thanks for the link. There is a lot of confusion surrounding these terms. Here is the definition of passive investing from the esteemed site, Investopedia:

    What Does Passive Investing Mean?

    An investment strategy involving limited ongoing buying and selling actions. Passive investors will purchase investments with the intention of long-term appreciation and limited maintenance.

    Unlike active investors, passive investors buy a security and typically don't actively attempt to profit from short-term price fluctuations. Passive investors instead rely on their belief that in the long term the investment will be profitable.

    I think you are correct to assume the average person believes that passive investing means limited trading, while active investing means to try and profit short term by frequently trading.

    ReplyDelete
  5. @Echo: This Investopedia definition seems to try to blend the various definitions people use. I prefer to separate them and hopefully eventually use different terms for the various definitions.

    ReplyDelete
  6. I usually think of the first definition as well. As a side point, the word passive seems so negative compared to the word active. That might just be my bias, though. Active implies getting thing done, versus letting things happen to you.

    There are negative ways to talk about activity though, too. Words like churn, and excessive trading come to mind. Passive investing could be described as low-fee or buy-and-hold to remove some of the lazy-bones stigma.

    ReplyDelete
  7. @Gene: You're right that these terms are somewhat loaded. Perhaps the answer is to avoid "passive" and "active" entirely and use new words to make it clear which definition one intends.

    ReplyDelete
  8. The word "Passive" can be misleading - sometimes it takes a lot of work to prevent yourself from making a trade. :)

    ReplyDelete
  9. @Mike: Thanks for the chuckle :-) Sometimes "active" can be misleading too, but in another context. When I hear someone say "our CEO is taking an active interest in my project", it's often the case that the CEO has never even heard of the project. I think this is the origin of "proactive" to distinguish actual activity from lies about activity.

    ReplyDelete
  10. Don't hold your breath for too long, I'd hate to see your face turn blue, lose all available oxygen and be unable to make a blogpost tomorrow.

    That aside, I guess I see these definitions not being right or wrong, rather, like most words in our english language, these words require contexting.

    ReplyDelete
  11. @My Own Advisor: I'm starting to get the feeling that people have well-established, but very different definitions for these words and it's easier to communicate effectively with different words.

    ReplyDelete