Passive Investing: What It Is and How It Works

Passive investing is a long-term strategy for building wealth by buying securities that mirror stock market indexes.
Elizabeth AyoolaNov 18, 2021

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What is passive investing?

To understand passive investing, think of the saying, "slow and steady wins the race."

Passive investing is when you buy securities that mirror stock market indexes, then hold them long term.

“And 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 and co-founder and co-CEO of 2050 Wealth Partners, based in Upper Marlboro, Maryland.

Like fine wine, the longer you hold your investments, the longer they have to mature and give you decent returns.

It’s a popular type of investing. According to a 2021 Gallup Investor Optimism Index, 71% of U.S. investors surveyed said passive investing was a better strategy for long-term investors who want the best returns. Of those surveyed, only 11% said “timing the market” was more important to earn high returns. A majority — 89% — said “time in the market” was more important.

Active investing vs. passive investing

So what’s the difference between passive and active investing?

In active investing, you research individual companies and buy and sell stocks in an attempt to beat the stock market.

In passive investing, you buy a basket of assets and try to mirror what the stock market is doing.

The type of investing you choose depends on what your goals are, says Christopher Woods, CFP and founder of LifePoint Financial Group, based in Alexandria, Virginia.

For example, he says if you’re investing 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.

So, what are the pros of active investing? The biggest advantage is that active 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

Pros

Lower maintenance: Constantly tracking the performance of your investments can be time consuming. As a passive investor, there’s no need to check your portfolio several times a day because you’re in it for the long haul. 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 25% 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: Every time you sell shares for a profit, you likely pay capital gains taxes. Passive investors hold assets long term, which means paying less in taxes.

Lower Risk: Passive investing can lower risk, because you’re investing in a broad mix of asset classes and industries, as opposed to relying on the performance of individual stock.

Cons

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 own the underlying stocks directly.

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 ETFs. Both are types of mutual funds — investments that use money from investors to buy a range of assets. As an investor in the fund, you earn any returns.

Because index funds and ETFs let you invest in holdings from various industries, passive investing can help you diversify, so even if one asset in your basket has a downturn, it shouldn’t affect your entire portfolio.

Index funds

Index funds can be a good option for the passive investor. They simply track the rise and fall of the chosen companies/assets within the index.

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 announced.

Index funds do require periodic rebalancing because index providers are continuously adding and dropping companies. Rebalancing is a part of portfolio management that ensures your investments still align with your goals.

» Need a broker for your mutual funds? Look at our top picks

ETFs

ETFs, also a type of mutual fund that tracks an index, are another way to get into passive investing. They might be a good choice for investors who want to be a little more hands-on when managing a passive portfolio.

The primary difference between ETFs and index funds is you can trade ETFs during market hours like stock. ETFs cut out the middleman, the mutual fund company. Instead of the money you invest in ETFs going to mutual fund companies to invest, you buy the fund from other investors who are selling shares they have.

Another perk of using ETFs for passive investing? They’re often cheaper to buy than index funds. You can buy one for the similar amount of a single stock, yet have more diversification than an individual stock would give. You can buy ETFs for stocks and bonds, as well as international ETFs, and you can diversify by sector.

» Dig deeper into ETFs vs. index funds

Robo advisors

If you want to buy and hit the snooze button, you can use a robo-advisor. They use computer algorithms and software to choose investments that align with your goals. You can also get the best of both worlds as many robo-advisors offer both index funds and ETFs. Automatic rebalancing is also often included with your account.

» Ready to start investing? See our list of the best robo-advisors

Active management

It is possible to use passive investments, yet still 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.

» Get started See our list of the best financial advisors

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