Is Active Investing Risky? What Investors Should Know

Active investing involves a hands-on approach to managing investment portfolios, leading to questions about its inherent risks. Investors seek to understand if this strategy, which aims to outperform market benchmarks, presents higher risks compared to other investment methods. This article explores active investing, from its definition to its specific sources and measures of risk.

Defining Active Investing

Active investing is an investment strategy where a fund manager or individual investor makes deliberate decisions to buy, sell, or hold securities. The goal is to generate returns that exceed a specific market benchmark. This approach contrasts with passive strategies, which aim to replicate an index’s performance. The core objective is to “beat the market” rather than simply matching its returns.

To achieve this, active managers engage in intensive research and analysis of individual companies and market trends. Methods include stock picking, where specific securities are chosen based on perceived undervaluation or growth potential. Market timing involves attempting to predict future market movements to buy low and sell high. Tactical asset allocation, adjusting the mix of asset classes in a portfolio based on market conditions, also forms part of this dynamic approach.

Sources of Risk in Active Investing

A primary source of risk in active investing is manager underperformance. The success of an active strategy relies on the skill and judgment of the fund manager to consistently make superior investment decisions. However, a majority of active funds, particularly in large-cap U.S. equities, have historically underperformed their benchmarks over extended periods, even after accounting for fees.

Another substantial risk factor is the higher cost associated with active management. Active funds incur greater expenses than passive investment vehicles. These include higher management fees, ranging from 0.10% to over 2% of assets under management, and potential performance fees, sometimes 10% to 20% of profits. Frequent trading also leads to increased transaction costs, such as brokerage commissions and bid-ask spreads, which can erode net returns.

Market timing and stock selection present additional risks. Accurately predicting market movements or consistently identifying winning securities is challenging. Poor timing decisions can lead to buying at high prices or selling at low prices, potentially missing out on significant market gains. Similarly, selecting individual stocks that fail to perform as expected can negatively impact portfolio returns.

Active portfolios may carry concentration risk, where a significant portion is allocated to a limited number of securities or sectors. Unlike diversified index funds that mirror a broad market, active managers might take larger positions in fewer holdings. If these concentrated positions perform poorly, the impact on the overall portfolio can be more pronounced, leading to higher volatility and potential losses.

Measuring and Perceiving Risk in Active Strategies

Risk in active investing manifests directly through portfolio volatility, which describes price fluctuations and swings in a portfolio’s value. An active manager’s decisions to deviate from a benchmark can lead to greater variations in returns, both positive and negative, compared to the market. This observable characteristic reflects the active risk taken in pursuit of higher returns.

Tracking error is a specific metric used to quantify this deviation, measuring how closely an active portfolio’s returns follow its benchmark. It is calculated as the standard deviation of the difference between the portfolio’s returns and the benchmark’s returns over a period. A higher tracking error indicates a greater divergence from the benchmark, implying a higher level of active risk. This metric helps investors understand the extent to which a manager’s active decisions influence performance relative to the market.

Underperformance relative to the benchmark is a tangible outcome of active investing risk for investors. While active management aims to surpass market returns, a consistent failure to do so represents a direct financial consequence of the risks taken. Studies show that a substantial percentage of actively managed funds do not outperform their passive counterparts over various time horizons. This outcome underscores the difficulty of consistently generating “alpha,” or excess returns above the benchmark.

Investor psychology also plays a role in how risk is perceived. During periods of market downturns or active fund underperformance, emotional responses can influence an investor’s assessment of risk. Behavioral biases can cause investors to overestimate their ability to select outperforming managers or to react negatively to short-term fluctuations. This psychological aspect can amplify the perceived risk of active strategies, especially when expectations of market outperformance are not met.