The aim of active investing is to outperform the market. The promise of beating a benchmark index like the S&P 500 or FTSE 100 makes this style of investing ideal for aggressive investors seeking to maximise investment returns.

Despite the potential for higher performance, active mutual funds have a high tendency to underperform after management fees are taken into consideration. Yet even with this lack of performance, active investing remains popular amongst institutional and individual investors. At the end of 2021, roughly 57% of assets under management by financial institutions were actively managed funds.

So, with that said, let’s explore:

• What is active investing?
• How are active investments managed?
• What should I consider before choosing an active investment?
• Do active investments really beat the market?
• Whether I should invest actively?

What is active investing?

Active investing is the ongoing buying and selling of shares in the stock market. Instead of trying to replicate an index’s performance, the goal is to actively monitor what’s going on in the financial world. That way, the investor can identify buying and selling opportunities caused by short- and medium-term trends to make a profit. And could even lead to superior returns.

That means active investing encompasses both individual stock pickers and traders. However, these two camps are vastly different in regard to time horizons.

This is the opposite of passive investing.

How is an active investment managed?

Active investments are usually managed through a fund, although individual investors can take on the challenge themselves. Every fund is managed by a fund manager and usually a team of analysts working under them. The Bridgewater hedge fund, founded by Ray Dalio, is an example of this.

Another popular group of funds with active management in recent years would be those founded by Cathie Wood as part of Ark Invest. Although in 2022, the performance of these funds was less than ideal.

Active fund managers typically have a lot more freedom than passively managed funds in terms of decision-making. And with little scrutiny on holding period lengths, positions can be opened and closed within a short space of time if needed.

Since the capital inside a fund belongs to investors, how does the fund make money? This is typically achieved through a small percentage fee at the end of each year, which is taken from the pool of capital of the fund rather than directly from investors’ wallets.

The effect of doing so causes the share price of the fund to suffer, but if the group is delivering solid returns, this typically isn’t enough to cause major declines in share price.

As I mentioned earlier, the track record of beating the market through actively managed funds is sketchy at best. Research shows that the majority of active funds fail to outperform their benchmark. And many do not stay long in the market.

Here’s what to consider before choosing an active fund

There are many factors to consider before deploying an investment strategy. Investing blindly is a grave mistake that often results in the destruction of wealth.

With that in mind, here are a few things I like to consider before making any form of active investment:

• Investment goal – If my investment objective is to try and outperform the market and make huge profits, then active investing is probably worth considering. However, this requires a higher level of risk tolerance that many individuals don’t own.
• Risk tolerance – Active investment comes with a higher level of risk and requires far more time and dedication to avoid falling into investing pitfalls. Consequently, if an investor can not afford to lose a large portion of their capital in pursuing greater returns, a passive investing approach might be more suitable. Although, this strategy is also not risk-free.
• Cost – With active investment comes more frequent trading commissions since the number of transactions in a year will be higher. An investor who wants to minimise cost should consider a more passive approach, I feel.

Should I consider active investing or passive investing?

A well-diversified portfolio enables an investor to mitigate a good chunk of company-specific risk. This is something that every investor in an index fund gets to benefit from immediately. After all, buying shares in an index fund is the equivalent of buying shares in every business within the underlying index in just one transaction.

However, active investors can also benefit from diversification in the pursuit of higher returns. And the ability to concentrate a portfolio is directly tied to the potential of outperforming the stock market.

Personally, I like both investing styles. My portfolio can unlock better results by using active investing to find buying opportunities. Blending in the passive investing style by holding my investments for the long-term keeps the number of transactions low, enabling my portfolio to enjoy the best of both worlds.

RELATED: Active vs Passive Investing: Which one is better?

Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.