What is passive investing?
Passive investing refers to an investment strategy with a minimal amount of trading.
As opposed to stock picking, passive investing means investors are not actively looking for individual companies to put their money in.
It is seen as a diversified buy-and-hold strategy for long-term wealth building that prefers exchange traded funds (ETFs) and mutual funds over individual stocks. Passive investing limits the continuous buying and selling of securities to make short-term profits.
The passive investing definition should not be confused with the passive income strategy, which refers to an income that doesn’t require a significant commitment of time or money.
Investing in index funds
A passive investment strategy typically involves tracking the wider market, for instance, through an index fund, which is one of the most popular types of passive investing.
As a passive investing example, an investor wanted to get exposure to US stocks from investing in ETFs that track S&P 500 (US500). Alternatively, they may want to track a specific market sector or theme, such as green energy or information technology.
Index funds allow investors to track the performance of their preferred area of the market, or the market overall, without having to pick individual stocks.
Passive vs active investing
Passive and active investing strategies have always been compared since they are the opposite ways to navigate the markets.
While active investing relies on a fund manager to time the market and generate higher than average returns through stock picking and trading, passive investing is a more hands-off approach where you rely on a broader index performance to generate returns on your portfolio.
Pros and cons of passive investing
While some may consider passive investing a conservative approach, there are some advantages to it as well as downsides.
Passive investing advantages
Expenses related to managing a passive fund are relatively low. As there is no continuous buying and selling stocks under passive investing, trading fees and other costs are minimised to keep the fund running.
When you are investing in passive funds, you know exactly what securities your portfolio holds at all times.
Since there is no active buying or selling of assets based on market movements, passive investing upholds transparency.
Historically, over a long-term timeframe, passive funds have outperformed actively managed funds.
During market downtrends, active investing can lead to discarding stocks which may outperform over a longer-term period.
Considering passive investing fosters the discipline of holding to a portfolio and without trading on the short-term volatility, passive investing can lead to a more consistent portfolio growth.
Passive investing downsides
Lack of flexibility
Considering passive investing involves tracking a specific index, investors may not be able to react to sudden market movements.
For example, if technology stocks are going through a downtrend, investors cannot choose to discard them from their portfolio if the index they follow continues to hold these stocks.
Passive investing involves no active management and research in an attempt to time the market and outperform benchmark returns.
Since there is no active buying and selling of securities based on their price movement, passive investing may lead to generating limited returns. Essentially, passive investors won’t be able to outperform the index returns.
Index funds are a popular way to practise passive investing, they contain a diversified basket of stocks. However, more often than not, there is less choice available for passive investors as they’ll only remain invested in the stocks that are offered in the index.