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Passive Investing

Updated on April 9, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Passive Investing?

Passive investing is an investment strategy wherein investors buy securities and hold them with a long-term goal in mind. Traders here do not involve in the frequent buying and selling of stocks. Instead, they invest in funds that mirror the major stock indexes and assess the performance of the securities to match the pace rather than attempt to outperform them.

What Is Passive Investing

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Index funds and Exchange Traded Funds are considered the most effective securities to invest in as these intend to mirror the indexes, like the Standard and Poor’s (S&P), NASDAQ, etc. This is the best strategy for those who aim to enjoy long-term goals than reap profits from frequent trading of stocks.

Key Takeaways

  • Passive investing refers to a strategy adopted by investors to optimize their returns by buying and holding a broad base of securities rather than churning portfolios by buying and selling them frequently.
  • The main aim is not to beat the market but to track portfolio performances and provide returns equal to that of the prominent stock exchanges of the country. This is usually done by investing in a low-cost, broadly diversified index fund.
  • Index funds, Exchange-Traded Funds (ETFs), and Direct Equity are the three types of passive investing.
  • Due to its simplicity of having to buy and hold a broad-based index of securities, passive investing tends to gain prominence among the masses. 

Passive Investing Strategy Explained

Passive investing is a long-term strategy that allows investors to buy securities of different types and have a diversified portfolio. Those who are not into reaping profits from short-term investments driven by market fluctuations and aim to have something big planned for the long term can opt for these investing schemes. 

As passive investors, individuals and entities do not actively participate in the buying and selling process but keep in touch with the market. They invest in securities that mirror the significant stock indexes and let them know how the investments perform. In addition, the process helps them keep their portfolio well-maintained per the market standards and watch the volatility. For passive investors, outperforming is not the aim. Instead, they intend to keep up with the current market situation.

This investing works on the “buy and hold” principle. The strategy does not aim at profit-making but ensures future financial security. The main aim is not to beat the market but to make an arrangement for the portfolio to track and provide returns equal to that of the prominent stock exchanges of the country. The investors invest in low-cost, broadly diversified funds to achieve this.

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Types

Investors looking for passive investing ideas get three options: index funds, exchange-traded funds, and direct equity.

#1 – Index Funds

An investor can purchase an index fund that goes on to hold stocks in replication to the country’s index merely. Then, the fund manager of the index funds makes all efforts to ensure that the tracking error is minimum and that the index fund’s performance aligns with that of the currently tracked index.

Passive Investing Types

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#2 – Exchange-Traded Funds (ETFs)

These are similar to index funds and follow the route of passive investing. However, the only difference is that the stock exchanges list ETFs from where traders can buy or sell them, leading to a transfer of ownership.

#3 – 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, NASDAQ, etc. Hence, the returns of the investor would mirror the returns of the index of the economy. In this case, the challenge for the investor would be to frequently track the index and make the necessary changes in their portfolio. 

Examples

Let us consider the following examples to understand the passive investing strategy properly:

Example #1

Mark buys a property in Los Angeles, intending to sell it in the future. However, as he is still employed as an investment banker and has sufficient earnings to spend on his family and his requirements, he keeps his goal of selling the property on hold. Then, after ten years, when he retires, he sells it at a higher price, which is the currently trending price and earns a profit. As a result, he ensures a financially secure retirement life. This is an example of passive investing in real estate – buy, hold, and sell when it’s the most fruitful.

Example #2

Recently, Yahoo Finance published a report on how effective passive investing is in volatile markets. The expert opinions in the report suggested that the market history depicts how the returns remain constant for consecutive years, be it positive or negative, in longer tenure. This means the profits and losses remain constant for years to come once recorded. Therefore, investors must put their money to work when the market is down instead of trying to time the market. This, as a result, helps create a virtuous investment circle, which keeps the market efficient.

Pros & Cons

Passive investing lets people invest in different portfolios and maintain a low-risk profile, but at the same time, makes the market stagnant if the majority of investors start opting for it. In short, the investment strategy comes with both positive and negative impacts. Some of the advantages and disadvantages of choosing passive investment funds and securities are listed below:

Advantages

  • It leads to the reduction of cost because of the infrequent buying and selling of securities. This means when the market is not active, the cost gets reduced.
  • The strategy allows investors to invest in different assets, helping them maintain a diversified portfolio.
  • Investment-related taxes get reduced as the market no more remains active.
  • It gives a simple investment option to investors. They can buy and hold the securities while keeping a watch on the market until the time they find it the most fruitful to sell.

Disadvantages

  • The strategy becomes less profitable if the active market outperforms and yields more returns than the passive investments.
  • Returns here might be long-term but not too high. Hence, it tends to encourage investors to spend more on active investment options.

Passive Investing vs Active Investing

The differences between passive and active investing are many. Some of them have been mentioned below in the tabular form:

CategoryPassive InvestingActive Investing
ProcessBuy and hold securities for longer termFrequent buying and selling of securities
ObjectiveMirror significant stock indexes to be at par with the marketInvestors try to outperform the market and reap more and more profits
TenureLong-term investment goalsBoth short-term and long-term investment objectives

Frequently Asked Questions (FAQs)

Why is passive investing better?

Passive investing is considered better as it involves reduced costs and allows investors to diversify portfolios. In addition, they are simple, easy to follow, and make for an excellent portfolio to own as it replicates and produces returns similar to the stock index, which is often considered the barometer for the economy.

How to start passive investing?

Passive investors can start by investing in index funds, ETFs, or real estate Investment Trust (REIT) funds. For this, they would require opening a brokerage account to start transacting. They can, therefore, buy and hold investments using those accounts.

Is passive investing a bubble?

The latest arguments suggest that the increase in the number of passive investors is causing the bubble to brew in the stocks they buy to hold. As these investors buy securities with market-cap weights, the major market stocks witness a significant price boost. On the contrary, the price of the smallest stocks goes down. This is what causes bubbles to brew.

This is a guide to what is Passive Investing & its meaning. Here, we explain how it works along with the types, examples, vs active investing. You can learn more from the following articles –

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