Once a month, I meet up with some smart people in my neighborhood to drink coffee and try to stave off mental decline by talking about hard financial topics: macroeconomics, taxation and sometimes even something useful, like investing. It's like Facebook chat, only you can smell the other participants.

At our last meeting, the topic was active vs. passive investing. Before we could get into that debate, however, we had to define our terms. I was arguing the passive investing side, which meant I had to come up with a definition of passive investing. This proved to be a lot trickier than I thought, and more fun.

I'm not going to get into the passive vs. active debate in this column. I just want to see if I can figure out what we're talking about before I wade into that debate in the near future.

"What is passive investing?" may seem like an arcane question that nobody but latte-fueled intellectuals should care about. On the contrary, pal: if you're saving money for the future, deciding whether to take an active or passive approach is among the most important decisions you'll make.

Who's Active?
Active investing, as I define it, means trying to beat the market over a particular time period using one or both of the following strategies:

Security selection. This is a fancy term for buying the right stocks (or bonds, or funds, or any other asset) and avoiding the wrong ones. It means having the foresight to buy Apple in the pre-iPod days and not to buy Netflix on the day after its IPO.

Market timing. Markets gyrate. If you can correctly predict those gyrations ahead of time, you can make a lot of money - or avoid losing it.

Passive investing means doing neither of those things. It means diversifying as much as possible by buying broad market index funds. It means owning the next Apple, but also the next Groupon. And it means not trying to time the market. That means staying in when stocks take a dive five days - or months, or years - in a row.

Passive investing also means making portfolio decisions based on personal circumstances, not on headlines or research.

Who's Passive?
With that definition in mind, let's cook up a couple of hypothetical investors and see who's passive and who's active. (Aren't these terms a little judgmental, by the way? That's why MintLife columnist Dan Solin likes to refer to passive investing as "smart investing.") This is my column, so I get to be the judge and jury. We'll start out easy.
Alice owns a bunch of individual stocks and bonds and trades them regularly.

Verdict: Active.

Bob owns no individual stocks or bonds, only low-cost ETFs, but he trades them regularly in response to perceived market trends.

Verdict: Active.

Charlie buys mutual funds, holds them and never trades. However, his mutual funds are actively managed, so the fund manager may be trading stocks within Charlie's funds.

Verdict: Active.

Donna buys diversified index funds or ETFs, holds them and never trades.

Verdict: Passive.

Rick Ferri, in his book "The Power of Passive Investing," puts these four investors into a handy chart, which I'm going to simplify and reproduce here.

Uses actively managed funds or individual stocks Uses index funds or ETFs
Trades Alice Bob
Doesn\'t trade Charlie Donna

As you can see, only Donna meets Ferri's (and my) definition of passive investing.

The Hard Cases
Now, let's ask some tougher questions.
Emily owns only index funds and ETFs, but she has decided on a 50% stock/50% bond portfolio.

Verdict: Not enough information.

If Emily has chosen a 50/50 portfolio because it's in line with her risk tolerance, she's passive. If she believes this portfolio looks like a winner for the moment, but intends to change it later when stocks look like a better bet, she's active.

Frank owns only index funds and ETFs in a 50/50 stock/bond portfolio, but he trades once a year or more to bring his portfolio back in line with its original allocation. That is, if bonds go up and stocks go down, he sells off some bonds to buy more stocks until he's back to 50/50. This is called rebalancing.

Verdict: Passive.

Rebalancing is about keeping your portfolio risk under control; it's not about trying to time the market.

Gene used to have a portfolio of 75% stocks/25% bonds. Recently he received an inheritance. He checked his retirement savings calculator and found that with the new infusion of cash, he could take less stock market risk and still have an excellent chance of reaching his savings goal, so he switched his allocation to 50/50.

Verdict: Passive.

Gene is changing his portfolio based on a change in his circumstances, not anything to do with market trends.

Hailey is a buy/hold/rebalance type like Frank. A couple of years ago, however, during the financial crisis, she noticed that prices on certain bonds had plummeted. She took the opportunity to buy some highly-rated bonds at bargain prices and permanently reduced her allocation to stocks.

Verdict: Hmmm.

I'm not sure. It smells like market timing, but is it?

Get Your Team Alice T-Shirts Here
Alice, our pure active investor, works hard at investing. She is up on the latest IPOs, valuations, interest rates and market trends. She has a whole folder of investing apps on her phone.

Meanwhile, Frank, our passive buy/hold/rebalance guy, doesn't know anything about any of that stuff, and he spends a few minutes a year managing his portfolio.

You can probably guess whose team I'm on, but let's talk about you: are you an Alice or a Frank, or someone else from our cast of characters? And why?

Related Articles
  1. Entrepreneurship

    Does Vanguard have a 401(K) Plan Suitable for a Small Business?

    Learn about the Vanguard Group's new 401(k) product for small businesses and how they've tailored their plan to appeal to small-scale operations.
  2. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  3. Mutual Funds & ETFs

    5 Vanguard Fixed Income Fund Underperformers

    Learn about three Vanguard fixed income mutual funds that underperform compared to their benchmark indexes. Find out why low expense ratios are important.
  4. Mutual Funds & ETFs

    Top 5 Natixis Funds for Retirement Diversification in 2016

    Discover five mutual funds from Natixis Funds that provide high income, growth and preservation of capital while diversifying a retirement savings plan.
  5. Mutual Funds & ETFs

    4 Mutual Funds You Wish You Could Include In Your 401(k)

    Discover four mutual funds everybody wishes were in their 401(k)s. Learn which five-star-rated no-load funds leave their competition in the dust.
  6. Stock Analysis

    If You Had Invested Right After Berkshire Hathaway's IPO (BRK.A)

    Learn how much you would now have if you had invested right after Berkshire Hathaway's IPO, and find out the classes of shares that you could invest in.
  7. Mutual Funds & ETFs

    ETFs Can Be Safe Investments, If Used Correctly

    Learn about how ETFs can be a safe investment option if you know which funds to choose, including the basics of both indexed and leveraged ETFs.
  8. Mutual Funds & ETFs

    Top 3 Allianz Funds for Retirement Diversification in 2016

    Discover the top three Allianz funds for retirement diversification in 2016, with a summary of the portfolio's managers, performance and risk measures.
  9. Mutual Funds & ETFs

    3 PIMCO Funds Rated 5 Stars by Morningstar

    Learn about three fixed income mutual funds managed by Pacific Investment Management Company (PIMCO) that have received five-star overall ratings from Morningstar.
  10. Mutual Funds & ETFs

    3 Invesco Funds Rated 5 Stars by Morningstar

    Learn about the top three mutual funds administered and managed by Invesco Ltd. that have received a five-star overall rating from Morningstar.
RELATED FAQS
  1. Are target-date retirement funds good investments?

    The main benefit of target-date retirement funds is convenience. If you really don't want to bother with your retirement ... Read Full Answer >>
  2. Do mutual funds require a demat account?

    A dematerialized account enables electronic transfer of funds. The account is used so an investor does not need to hold the ... Read Full Answer >>
  3. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  4. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  5. Does OptionsHouse have mutual funds?

    OptionsHouse has access to some mutual funds, but it depends on the fund in which the investor is looking to buy shares. ... Read Full Answer >>
  6. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  3. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  4. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  5. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  6. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
Trading Center