Passive investing is a long-term approach in which investors purchase and keep a diverse range of assets in order to match, rather than outperform, the market.
The most typical method of passive investing is to purchase an index fund, whose assets reflect a certain or representative portion of the financial market.
For example, suppose you buy a representative benchmark, such as the S&P 500 index, and hold it for an extended period of time.
Active vs. passive investing
Methods of passive investing try to avoid the fees and low returns that can come from trading a lot. The goal of passive investing is to build wealth slowly. When you invest passively, you buy a security and keep it for a long time. This is also called a “buy-and-hold” strategy.
Active traders try to make money from short-term price changes and market timing, but passive investors don’t. A passive investment strategy is based on the idea that the market gives positive returns over time.
Most passive managers think it is hard to think better than the market, so they try to match the performance of the market or a sector.
Passive investing tries to copy the performance of the market by putting together well-diversified portfolios of single stocks, which would require a lot of research if done individually.
When index funds came out in the 1970s, it became much easier to get returns that were in line with the market. In the 1990s, exchange-traded funds (ETFs) that tracked major indices, like the SPDR S&P 500 ETF, made the process even easier by letting investors trade index funds like stocks.
Pros and cons of passive investing
The goal of passive investing is to build wealth over time, not to make a lot of money quickly. The main advantages of a passive strategy are:
Pros
A good outlook
Passive investing strategies are based on the idea that investors can count on the stock market going up over time. A portfolio will grow along with the market if it looks like the market.
Stable gains
Morningstar’s active/passive barometer says that over the long term, passive funds do better than active ones. Only 25% of active funds beat passive funds over the past 10 years.
Low prices
Transaction costs (commissions, etc.) are low with a passive strategy because it is slow and steady and there aren’t many trades. Management fees for funds are unavoidable, but most ETFs, which are the preferred vehicle for passive investors, keep fees well below 1%.
Diversified holdings
Investors can also diversify their portfolios in a quick and cheap way with passive strategies. This is because index funds hold a wide range of securities from their target benchmarks, which spreads risk over a large area.
Less risk
Diversification almost always means less risk because it is what it is. Investors can also diversify their holdings even more within sectors and asset classes by using more targeted index funds. This depends on which funds they choose.
Even though passive investing has a lot of pros, it also has some cons.
Cons
No flexibility
Even if the managers of an index fund think that the performance of their benchmark will go down, they usually can’t do things like reduce the number of shares they own or buy other securities to protect their portfolio.
Fewer windfalls
Since passive funds are made to match the market, investors aren’t likely to get the big wins that can sometimes come from actively managed funds. In other words, you can’t catch that stock star on the rise. Even if a fund did this, the returns might not be as high because of the other investments in the portfolio.
Less pain, less gain
In the long run, buying and holding can be a good way to make money (at least a decade or two). You can handle the changes in the market. But making the risks the same also makes the rewards the same. Most of the time, active investing gives better results and bigger gains over shorter periods of time.
Passive investment strategies
There are many ways to invest without doing anything. You can buy index funds or exchange-traded funds (ETFs). Both are mutual funds, which use money from investors to buy a variety of assets. If you put money into the fund, you get money back.
Passive investing can help you diversify because index funds and ETFs let you invest in holdings from different industries. This means that if one of your assets goes down, it shouldn’t affect your whole portfolio.
Index funds
Index funds can be a good choice for investors who don’t want to do much work. They just watch how the chosen companies/assets in the index go up and down.
One difference between index funds and ETFs is that you can only buy and sell index funds at set prices after the market closes and the index fund’s net asset value is released.
Index providers are always adding and dropping companies, so index funds do need to be rebalanced from time to time. Rebalancing is a part of managing your portfolio that makes sure your investments still match your goals.
ETFs
ETFs are another way to get into passive investing. Like mutual funds, they follow an index. They might be a good choice for investors who want to manage a passive portfolio with a little more involvement.
The main difference between exchange-traded funds (ETFs) and index funds is that you can trade ETFs like stocks during market hours. ETFs cut out the mutual fund company, which was in the middle. When you invest in ETFs, your money doesn’t go to a mutual fund company to be invested. Instead, you buy the fund from other investors who are selling their shares.
Another good thing about investing passively with ETFs? Most of the time, they cost less to buy than index funds. You can buy one for the same price as a single stock, but it gives you more options than a single stock would. You can buy both stock and bond ETFs, as well as international and sector-specific ETFs.
Robo advisors
You can use a robo-advisor if you want to buy something and hit the snooze button. They use computer programs and algorithms to find investments that match your goals. Many robo-advisors offer both index funds and ETFs, so you can get the best of both worlds. Your account may also have automatic rebalancing built in.
Bottom line
The average retail investor’s preferred strategy is passive investment. It’s a simple, low-cost approach to invest that eliminates the need to spend a significant amount of time studying equities and monitoring the market.
The strategy’s core concept is that, in the long run, the market’s growth will favor those who wait. And less trading gives maximum profits.
While the buy-and-hold strategy has few drawbacks, it is not for everyone. Finally, passive investing is better suited to investors with long-term goals, such as retirement savings, and who like to remain hands-off.
Investors who desire more hands-on control over their portfolios, or who don’t have time for the waiting game, are unlikely to benefit from a passive approach. If they want to try to outperform the market and are ready to pay higher fees to do so, an active strategy is the way to go.
