Active vs. Passive Investing: What's the Difference?

This article is an excerpt from the Shortform book guide to "Money: Master the Game" by Tony Robbins. Shortform has the world's best summaries and analyses of books you should be reading.

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What’s the difference between active and passive investing? Which one is smarter to practice?

In his book Money: Master the Game, Tony Robbins says that passive investing is the smarter approach, as you’re less like to lose money than you would with active investing. However, he does say that you can use either strategy when dealing with your investments.

Here’s Robbins’ explanation of active vs. passive investing.

Active vs. Passive Investing

According to Robbins, the average investor has better options than ever before to become wealthy. While pensions have declined, social security funds have dwindled, and many 401(k)s are insufficient, there are also new and powerful financial tools available. It’s up to you to create your specific financial strategy, but Robbins asserts that investing wisely can make you wealthy.

(Shortform note: When learning how to invest for yourself, one key skill is learning how to write an investment thesis, a statement about your investment objective, your ideas about investing, and your reasoning for why they’ll work. For example, you might state that your objective is to build steady passive income over time, by committing to living below your means, saving extensively, and trusting that you’ll gain over time.)

Robbins recommends thinking of money as a game. This doesn’t mean it’s trivial—it means you can learn how the game works and study the pros to improve your chances of winning. Crucially, you need to know how and how not to play the game to maximize your chances of winning. There are two ways to play: by investing actively or passively. Let’s look more in-depth at active vs. passive investing.

Active Investing

In active investing, you bet on the daily ups and downs of the market. Active investors buy and sell assets—such as bonds, stocks, and commodities—on a daily basis, trying to predict trends and beat the market.

This high-risk approach is called day trading, and Robbins recommends avoiding it. Major financial firms have sophisticated technologies that enable them to trade assets in microseconds, as well as teams of experienced analysts who spend every day studying the market. Trying to compete with them is like challenging a modern military with a water gun and a hobby horse. Further, most active managers—investors who trade with funds contributed by the average person—fail to beat the market. Fully 96% lose over the long term.

(Shortform note: In I Will Teach You to Be Rich, Ramit Sethi agrees that it’s good practice to avoid mutual funds and active investing. He explains that many firms hide poor performance by dropping funds that fail and ranking only the funds that perform well—so a firm could start with 15 funds, but only three perform well while the others tank and disappear.)

Passive Investing

In passive investing, you buy and hold a collection of assets to mimic the market’s growth. Over time, the interest on your investments will yield steady returns, and a well-diversified portfolio—your collection of assets—can mitigate losses. This is the essence of Robbins’ approach: Build an investment portfolio that grows steadily while losing as little as possible.

Robbins says that the average investor can win with passive investing thanks to one simple mechanism: compound interest. Each time you earn interest on an investment, that money compounds with your initial investment, which is called your principle. Since your principle is now larger, the next return will be slightly larger. It again compounds with your principle, increasing the size of your next return. For example, $10,000 invested with an annual return of 7% becomes $19,671.51 in 10 years, $29,521.64 in 20 years, and it rockets up to $76,122.55 in 30 years.

Active vs. Passive Investing: What’s the Difference?