Passive Investing (Definiton, Examples)

Passive Investing Definition

Passive investing refers to a strategy adopted by investors to optimize their returns by avoiding frequent churning of portfolios by buying and selling securities, but rather buying and holding a broad base of securities.

In this era where active managers try to beat the market by buying and selling securities by undertaking all sorts of analysis, passive investing believe in buying and holding a broad-based portfolio which is usually an index fund. In active investing the cost tends to be higher because of the churning of securities and hence the returns that are expected by the investors also tend to go higher.

Types of Passive Investment Strategies

Given below are the types of passive investment strategies that can be adopted by the common investor.

Direct equity: An investor can adopt a passive investment strategy by buying the stocks in the index to the same proportion of the index such as Dow Jones. Hence the returns of the investor would mirror the returns of the index of the economy. The challenge for the investor, in this case, would be to frequently track the index and make the necessary changes in his portfolio.
Purchase of index fund: An investor can choose to simply purchase an index fund that goes on to merely hold stocks in replication to the index of the country. The fund manager of the index funds would make all efforts to ensure that the tracking error is minimum and the performance of the index fund would be very closely aligned to that of the index which is currently tracks.
ETF: Exchange Traded Funds (ETFs) are similar to index funds and follow the route of passive investing, the only difference being that the ETF is listed on a stock exchange and can be bought and sold by investors which will only lead to a transfer in ownership.

How Passive Investing Works?

Passive investing adopts the style of ‘buy and hold’ philosophy. It tends to avoid the frequent buying and selling of securities thereby reducing significant costs. It is a simple investment strategy that aims to diversify investment holdings in many securities rather than holding single stocks or bonds.

The main aim is not to beat the market but rather the portfolio should track and provide returns equal to that of the prominent stock exchanges of the country and this is usually done so by investing in a low cost, broadly diversified index fund.

The idea was first mooted by John Bogle of the Vanguard group by forming the first index fund.

Examples of Passive Investment

Given below are some examples of how investors can adopt a passive investment strategy.

Index fund: Investors can use the route of passive investment by having to choose some of the index funds in US such as Vanguard 500 index fund (VFINX), Vanguard total stock market index fund (VTSMX), Fidelity 500 index fund (FUSEX), Schwab Total Stock Market Index fund. (SWTSX).
ETF: Investors can also adopt passive investment through holding Exchange Traded Funds present in the US like Vanguard Mega Cap ETF, Schwab Broad Market ETF.

Advantages

Given below is how the index fund tends to benefit the investors

Reduction in costs: Compared to active investing passive investing tends to significantly reduce expenses owing to reduced churning as there is no frequent buying and selling of securities.
Diversification: Rather than having to hold single security, index investing strongly believes in having to diversify among various stocks that track the stock index of the country, thereby reduce concentration and promote diversification.
Reduction in taxes: By having to limit the constant buying and selling of securities, passive investing also tends to greatly reduce various taxes related to investments.
Simplicity: This type of investing tends to be popular among the masses is owing to the simplicity involved in adopting this method. One has to merely hold a broad-based index fund or an ETF or simply invest in stocks that track and replicate the index and that is all there is. Hence the method is quite simple and easy to follow.

Disadvantage

Passive investment does not go on to beat the market, rather have the returns in line with that of the market. There are times when an actively managed fund goes on to deliver supreme returns beating the market to a great extent.

Passive investing often tend to miss out on such occasions and will be limited to a smaller return in line with the index. Nevertheless, such instances are really rare and the actively managed funds may also go down south with grossly huge negative returns if the markets were to correct whereas the index funds would not be greatly impacted to such extent

Limitations

Passive investing tends to limit itself to the return of index funds as they make efforts to replicate the index funds in the economy and are thus constrained to only the returns that can be obtained by holding such a fund. However, they do miss out on superior returns which are at times achieved by the actively managed fund managers

Difference Between Active and Passive Investing

Active investing makes efforts to beat the market by achieving superior returns whereas passive investing merely adopts to returns in line with market
Active investing indulges in frequent buying and selling of securities whereas passive investing adopts a ‘buy and hold’ strategy
Active investing incurs significant expenses owing to churning of portfolios whereas passive investing reduces expenses to that extent

Conclusion

Passive investing owing to its simplicity of having to buy and hold a broad-based index or securities tend to gain prominence among the masses. They are simple and easy to follow. They only miss out on the rare superior returns that active funds tend to generate.

Nevertheless, they make for an excellent portfolio to own owing to the fact it does go on to replicate and produce returns similar to the stock index that is often considered the barometer for the economy.