Passive Investing: What It Is and How It Works
Passive investing is a hands-off investment strategy that aims to mirror, rather than beat, stock market returns.
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What is passive investing?
Passive investing is a long-term strategy for building wealth by buying securities that mirror stock market indexes and then holding those securities for a long period of time.
To understand passive investing, think of the saying, "slow and steady wins the race."
“The goal of you investing this way is that you basically want to replicate the returns of that particular market index,” says Rianka R. Dorsainvil, a certified financial planner in Lanham, Maryland.
Like fine wine, the longer you hold your investments, the longer they have to mature and provide decent returns.
Active investing vs. passive investing
The main difference between passive and active investing is that active investing involves more frequent trading in an attempt to beat the stock market, and passive investing involves purchasing a basket of securities whose value fluctuations will mimic the fluctuations in the stock market as a whole.
Choosing active versus passive investing depends on what your goals are, says Christopher Woods, CFP Silvis Financial in Charlotte, North Carolina.
When passive investing is better
Woods says if you’re investing the money in a retirement account, where you’re planning to hold investments for 20 years or more, passive investing may be a better option because you won’t incur the same fees as you would if you were frequently buying and selling.
“If you think about the cost savings in a passive investment over the course of 20 or 30 years, it’s significant,” Woods says.
How much risk you’re willing to take also plays a role. If you run at the sight of stock charts or can’t handle the suspense that can come with active trading, passive investing may eliminate the sweaty palms and accelerated heart rate.
When active investing is better
The biggest advantage of active investing is that investors can handpick their investments, says Kashif A. Ahmed, a CFP and president of American Private Wealth LLC, based in Bedford, Massachusetts.
“Not everything in an index is worth buying,” he says.
Investors ready to put in the work and research individual stocks may prefer to choose where they put their money. What rewards could they reap from all that hard work? Potentially winning big and beating the market.
» Learn more about active vs. passive investing
Pros and cons of passive investing
Lower maintenance
Steady returns
Lower fees
Lower capital gains taxes
Lower risk
Limited investment options
May not get above-market returns
Advantages of passive investing
Lower maintenance: Constantly tracking the performance of your investments can be time-consuming. As a passive investor, there’s less need to check your portfolio several times a day. You don’t have to worry about trying to predict the winners and losers in the stock market — you’re simply riding the wave.
Steady returns: According to Morningstar’s active/passive barometer report, passive funds outperform active ones in the long term. In the past 10 years, only about 20% of active funds beat passive funds.
Lower fees: Passive investing doesn’t require as much buying and selling as active investing, which can mean lower expense ratios — the percentage of your investment that you pay the fund. “I’ve seen anywhere from 1.5 to 1.25% in fees for a fund that we can replicate in an ETF for 0.2%, and so that’s a drag on the return of the investment for the investor,” says Dorsainvil.
Lower capital gains taxes: If you sell shares for a profit, you may pay capital gains tax. Passive investors hold assets long term, which may mean paying less in taxes.
Lower risk: Passive investing can lower risk through diversification, because you’re investing in a broad mix of asset classes and industries, as opposed to relying on the performance of individual stock.
Disadvantages of passive investing
Limited investment options: If you invest in an index fund or buy an exchange-traded fund, or ETF, you can’t handpick each investment or drop companies you don’t think are worthwhile, because you don’t directly own the underlying stocks.
May not get above-market returns: Because your goal is to match the market average, you may not achieve above-market returns.
Passive investing strategies
There are several ways to be a passive investor. Two common ways are to buy index funds or buy ETFs. Both pool money from investors to buy a range of assets. This diversification means that even if one asset in your basket has a downturn, it shouldn’t take the entire portfolio down with it.
Index funds
Index funds simply track the rise and fall of the companies/assets within the index.
You can only buy and sell index funds after the market closes and the index fund’s net asset value is announced.
Index funds do require periodic rebalancing because index providers are continuously adding and dropping companies. Rebalancing is a part of portfolio management and ensures that investments still align with goals.
ETFs
ETFs also track an index. They might be a good choice for investors who want to be a little more hands-on when managing a passive portfolio.
Unlike index funds, you can trade ETFs while the market is open That’s because you buy shares of the ETF from other investors instead of directly from the fund company.
ETFs are often cheaper than index funds. You can often buy one for the similar amount of a single stock, yet have more diversification than an individual stock would provide.
You can buy ETFs for stocks and bonds, as well as international ETFs, and you can diversify by sector.
» MORE: ETFs vs. index funds
Robo advisors
Robo-advisors are companies that use computer algorithms and software to automatically choose investments that align with your goals. Many robo-advisors offer index funds and ETFs. Automatic rebalancing is also often included.
Active management
It is possible to use passive investments to actively manage your portfolio, Ahmed says. The primary way to do this would be through diversification.
“You might say, well I want my portfolio to be X percent large cap American, X percent international, some emerging markets, some sectors, and you decide the percentage and how you want to slice up your pizza. … Then you can use index ETFs to build that portfolio. And then actively rebalance it and trade it.”
Another way to actively manage a passive portfolio is through direct indexing. This is when you own the stocks in an index directly, and it’s possible because you can buy fractional shares of a stock. With direct indexing, you can manage your portfolio yourself and customize the index in any way you like.
That said, it's not always easy to choose the investments in your portfolio, so if you need help, consider reaching out to a financial advisor.
