Active investing is like betting on who will win the Super Bowl, while passive investing would be like owning the entire NFL, and thus collecting profits on gross ticket and merchandise sales, regardless of which team wins each year.
Active investing means you (or a mutual fund manager or other investment advisor) are going to use an investment approach that typically involves research such as fundamental analysis, micro and macroeconomic analysis and/or technical analysis, because you think picking investments in this way can deliver a better outcome than owning the market in its entirety.
Using the NFL analogy, you would study all the players and coaches, go to preseason training, and based on your research make an educated bet as to which teams would be on top for the year. Would you be willing to bet your money on your ability to choose right? An active investor or active strategy is doing just that.
With a passive approach you would buy index funds and own the entire spectrum of available stocks and bonds. It would be like owning the NFL; not every team is going to win, but you don't care because you know some merchandise is bound to be sold each year. With a passive approach you simply want to make money based on the collective outcome of all stocks and bonds pooled together.
Passive Captures the Return of an Entire Market
When you take this analogy, and apply it to investing, first you look at the entire market of available stocks. A passive investor wants to own all the stocks, because they think as a whole, over long periods of time, capitalism works, and they are likely to receive higher returns from investing in the entire stock market than by trying to pick the individual stocks which will outperform the market as a whole.
Actively Managed Funds vs. Passive Funds
When you look at mutual funds, an actively managed large cap mutual fund will try to pick the best 100-200 stocks listed in the S&P 500 Index. A passive fund, or index fund, would own all 500 stocks that are listed in the S&P 500 Index with no attempt to pick and choose among them.
Each year academic studies are conducted to compare the returns of actively managed funds to the returns of passive funds. Studies show that in the aggregate over long periods of time actively managed funds do not generally deliver returns higher than their passive counterparts. I explain why in How to Find the Best Mutual Funds. The reason why has to do with fees. Active funds incur higher costs and the fund manager must first garner additional returns to cover the costs before the investor would begin to see performance that was higher than the comparable index fund.
Why does an active approach cost more? It takes time to do research, and actively managed funds spend more money on overhead and staffing. In addition they have higher trading costs as they move in and out of stocks. If the index earns 10%, and the fund has 3% a year in costs, it must earn 13% just to have a net return equivalent to its index.
Passive Can Be More Tax Efficient
Passive funds do not do a lot of trading, which means not only do they have lower fees, but they also have less capital gains distributions that will flow through to your tax return. If you invest using non-retirement accounts this means a passive approach used consistently may reduce your ongoing tax bill. If you want to combine active and passive approaches you may look at putting actively managed funds inside tax sheltered accounts like IRAs, while using a passive approach or a tax-managed fund for non-retirement accounts.
Misunderstandings About Active vs Passive
Most of the time the active vs. passive debate is focused around whether a mutual fund can outperform its index. For example, studies may look at how many large cap funds outperform the S&P 500 Index. However, many funds and investment approaches are not restricted to a type of stock or bond. For example multi-cap funds may be able to own large or small cap stocks depending on what the research analysts think might offer the best performance. In this case you might measure the long term results of such a fund against something like Vanguard's Total Stock Market Index Fund.
Additional confusion comes from the fact that Investment advisors may use passive index funds, but use a tactical asset allocation approach to decide when the portfolio should own more or less of a particular asset class. In this way passive funds are being used within an active or semi-active approach.
Passive Investing Best for Most
I believe most investors are better off following a passive investment approach. If you are not the do-it-yourself type, then work with an investment advisor who uses passive funds. If you find you have the time to do your own research and you enjoy spending hours a day at the computer working on your portfolio, than a more active approach might work for you.