Passive investing (or indexing) involves purchasing diversified portfolios of all the securities in an asset class. Active investing involves overweighting securities and sectors within an asset class believed to be undervalued and underweighting securities and sectors believed to be overvalued. Purchasing a security, a stock for example, is effectively an active investment that can be measured against the performance of the stock market itself (and purchasing a corporate bond can be measured against an index of comparable corporate bonds). When compared to a passive investment in a stock index, the purchase of an individual stock can be viewed as a combination of an asset allocation to stocks and an active investment in that stock with the belief that it will outperform the stock index.
Arguments can be made for both active and passive investing but a much larger percentage of institutional investors choose to invest passively than do individual investors. The arguments for passive investing include reduced costs, generally lower risk (although there is another related discussion regarding investing risks - see discussions related to Fundamental Anomalies and Market Cap Effects), tax efficiency, and the fact that historically, passive funds outperform a majority of active funds. The arguments for active investing are that there are Anomalies in securities markets that can be exploited to outperform passive investments and the fact that some investors and managers have outperformed passive investing for long periods of time (but the odds of being able to identify them in advance are not good). Active management is ultimately a negative sum game since it has associated costs, and is thus speculative. Sell also
The active versus passive decision does not have to be a one or the other decision. In fact, a common argument is to invest passively in asset classes considered to be very efficient, and invest actively in asset classes considered to be less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively (for example you can invest half of your stock allocation in an index fund and the other half in active funds). Investors can also invest actively in sectors in a passive manner. For example, you can invest in an index fund or ETF of small stocks if you think small stocks will outperform large stocks, or you can invest in a passive country fund or ETF if you believe a particular country will outperform the rest of the world.
Why do active managers succeed or fail? Their are two main issues. The first is they outperform on a pre-cost basis either due to skill (or lack thereof) or luck. Determining which is responsible takes time. The second major factor is the costs. If we start with 100 managers, on a pre-cost basis we would expect 50 to outperform due to skill/luck and 50 to underperform after one year. With costs added the 50% that underperform will increase after one year from 0 to roughly 8 (more for higher costs, less for lower costs). If we go out to a much longer period, say 20 years the number that will underperform due to costs will likely rise to roughly 35. In other words, over long periods of time like 20 years we can expect 50% of active stock investors to underperform because they have no skill or are unlucky, and 35% (more than 1/3) will underperform because of costs. This is a critical distinction. These 35% would have outperformed if not for costs. The 50% that underperformed before costs, had both their losses and the costs on top of it. And finally the 15% that succeed have their returns reduced by the costs. Adding insult to injury the typical correlation between an active stock fund manager and the broad market tends to be around 88%. That means the costs incurred in active management are getting 88% market/index returns and 12% variation with all of the costs attributable to that 12% of variation.
