An active investment strategy tries to earn higher returns by identifying mispriced securities. Active investors believe that some securities are undervalued or overvalued and try to profit from these pricing errors.
A passive investment strategy does not try to beat the market. Instead, it focuses on holding a diversified portfolio for the long term, usually at a lower cost.
In efficient markets, passive strategies are often preferred because prices already reflect information. Active strategies may not generate enough extra return after considering costs.
Example:
Suppose an active fund gives a return of 13% in one year. A passive index fund gives a return of 12% in the same year.
However, the active fund charges 2% as management fees, while the index fund charges only 0.3%.
After costs:
Active fund return = 13% – 2% = 11%
Passive fund return = 12% – 0.3% = 11.7%
Even though the active fund performed better before costs, the passive fund gave a better return after costs.
This is why cost plays an important role in market efficiency and investment strategy.
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