Active Investing

Active investing is an approach to owning securities in which the investor attempts to improve on the return of simply holding a broad market, either by selecting individual securities expected to outperform or by moving in and out of the market at chosen moments. The two are separable decisions and either one alone makes a position active.

There is no definition to look up, and that is worth stating because a neighboring phrase does have a settled meaning in the fund industry. Active management describes a fund that employs people to select its holdings, which is a property of a product a person can buy. Active investing describes what a person does with whatever products they own, including index funds. This page is about the second. The Securities and Exchange Commission's investor glossary has no entry for "active investing", so the words carry industry meaning rather than legal meaning.

The binary is the wrong picture, and holding the wrong picture is how people misjudge their own portfolios. Almost nobody is at either end. An investor who holds a broad index fund for the bulk of a portfolio and keeps a tenth of it in individual companies has taken a small active position. So has one who holds only index funds but shifts the mix when the outlook changes, or one who stops contributing because the market looks expensive. The useful question is not which camp you are in but how large the active portion is and what it would have to earn to be worth holding.

The counterparty is the half of the trade that is easy to forget. Buying a security means someone sold it to you at that price, and selling means someone bought. Both sides saw the same public filings and the same price. So an active decision is not simply a judgment that a company is good or that the moment is poor; it is a judgment that you have reached a better conclusion than the person taking the other side, who may be a professional doing this full time with better data. That framing does not make the judgment wrong. It sets the standard the judgment has to clear.

What trying costs, and why the costs are the certain half. Three arrive regardless of the outcome. The first is the bid-ask spread, the gap between the price at which a security can be bought and the price at which it can be sold at the same instant, which is paid on the way in and again on the way out, whether or not the broker charges anything else for the trade. It is typically widest on thinly traded securities, which are often the ones an active investor believes are overlooked. The second is tax, and it applies only in a taxable account: a gain realized on a holding owned for one year or less is taxed as ordinary income rather than at long-term capital gains rates, so selling early converts a lower rate into a higher one on the same profit. The third is time and attention, which is real even though no statement reports it.

The judgment being made is usually a judgment about other people. The ordinary reasons an active position is taken are behavioral rather than analytical: a company has been in the news, a sector has risen for two years, a decline feels like it must continue. Overconfidence bias, recency bias and herd mentality each describe a specific way that happens, and panic selling describes the version that shows up in a falling market. An investor considering an active position is generally better served by asking which of those is operating than by refining the forecast. The comparative record of professionally managed funds against their benchmarks is a separate question, and it belongs with index funds rather than here.

An active position starts with a view: that a security is worth more or less than its price, or that the market as a whole is about to move. The investor acts on the view by buying, selling or shifting the mix, and then either the view is borne out or it is not. The costs of acting are incurred at the moment of the trade, and they are known in advance; the benefit is uncertain and arrives, if at all, later.

A hypothetical example of one cost that is easy to overlook. Priya buys a stock in a taxable account and sells it eleven months later at a gain of $8,000. Her ordinary income falls in the 24% bracket, and her income puts her long-term capital gains in the 15% band.

Because she held the shares for one year or less, the gain is taxed as ordinary income: $1,920 ($8,000 multiplied by 0.24). Had she held for more than a year before selling, the same $8,000 would have been taxed at the long-term rate: $1,200 ($8,000 multiplied by 0.15). The decision to sell when she did cost $720 in tax on a profit that was identical either way, and that $720 is on top of the spread paid on both trades. So the sale had to be better than waiting by at least that much before it added anything, which is the arithmetic an active decision in a taxable account has to clear. All figures are illustrative.

Pros

• Concentrating in securities you have genuinely researched is the only route to a result different from the market's, in either direction.
• Some parts of a portfolio have no passive version, so an investor holding a private business or a concentrated equity grant is making active decisions whether or not they call them that.
• Selling a position for a reason outside the market, such as needing the money or reducing an oversized single holding, is an active decision that has nothing to do with forecasting.
• Following individual companies closely can make an investor better at reading the filings and disclosures behind everything else they own.

Cons

• The costs of trying are certain and immediate while the benefit is uncertain and later, which is the least favorable shape a decision can have.
• In a taxable account, realizing a gain within a year converts a lower tax rate into a higher one on exactly the same profit.
• Concentration reintroduces the risk that one company's failure damages the portfolio, which a broad fund removes.
• The judgment is being made against a counterparty who may be better informed and is doing this professionally.
• Frequent trading gives more opportunities for a behavioral error to become an actual transaction.