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Jul 19, 2022
By Team Stash
Passive investing is a strategy meant to build wealth gradually by buying securities and holding them long-term. Also known as a buy-and-hold strategy, passive investing methods seek to avoid the fees and risk often associated with frequent trading. It assumes that the market posts positive returns over time, so it’s better to put time into the market instead of trying to time the market. Index funds, which can include mutual funds and exchange-traded funds (ETFs), are designed to mimic the performance of market indexes, making them the primary player in a passive investment strategy.
In this article, we’ll cover:
- How passive investing started
- Active investing vs passive investing
- Building your passive investing strategy
- Benefits of passive investing
- Downsides of passive investing
The invention of the passive investing concept
Jack Bogle, the founder of The Vanguard Group, pioneered the index fund in 1975. Also known as a passive fund, index funds were a revolutionary addition to the market because they allowed retail investors with a brokerage account to compete with professionals. When index funds were first introduced, mutual funds were the main vehicle for passive investing. Since then, ETFs have become the most common type of passive fund. Today, around 71% of investors agree that passive investing is generally superior to active investing for maximizing long-term market returns.
Active vs. passive investing
As the names imply, active investing requires a more hands-on approach, while passive investing requires less frequent buying and selling of stocks and other securities (not to be confused with passive income).
Active investing is done with the goal of “beating” or “timing” the stock market, usually with a very hands-on portfolio manager. It tends to be riskier, as investors must guess how stock prices may change day-to-day, or even within a single day. This type of investing can also be more expensive as active investors pay more fees associated with making trades. It’s geared toward more aggressive investors who aim to take advantage of short-term price fluctuations in the market.
On the other hand, passive investing is a long-term game. It can be a more cost-effective way to invest because fewer trades mean fewer fees. Passive investors build a diversified portfolio, often with the support of a robo advisor, then adopt a “buy and hold” mentality, resisting the urge to predict or react to market fluctuations. Successful passive investing rides out short-term setbacks in favor of focusing on long-term returns and overall portfolio performance, which may reduce the risk associated with market volatility.
| Active investing (hands-on) | Passive investing (hands-off) |
|---|---|
| High volume of trades | Buy-and-hold approach |
| Hands-on portfolio management | Less frequent portfolio management |
| Tends to focus on individual securities | Tends to focus on a diversified portfolio |
| Higher risk | Lower risk |
| Geared toward short-term returns | Geared toward long-term returns |
Passive investing strategies
While many different types of investments may support a passive strategy, passively managed mutual funds and ETFs are common choices because they have a degree of diversification built in. Index funds are especially suited to passive investing because they aim to mimic the way indexes like the S&P 500 behave; these indexes often reflect steady growth over time. ETFs are unique in that they can be bought and sold on a stock exchange the same way that a regular stock can.
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Pros of passive investing
Passive investing relies on a diversified portfolio that’s built to see slow but steady gains over time. This approach is usually a simple, lower-risk, less expensive way to invest, especially for beginning investors. Additionally, the buy-and-hold strategy typically doesn’t result in a massive yearly capital gains tax. Pros of passive investing include:
- Low maintenance
- Tax-efficient
- Diversified investments
- Lower fees
- Less risk
- Steadier returns
Cons of passive investing
Investors hunting for large, short-term gains may find passive investing too limited. The strategy excludes opportunities to jump on a stock whose price may rise quickly, then sell before it falls; this active investing approach can be risky, but may provide a market return that exceeds overall market performance. If you have an aggressive risk profile, you might see some cons to passive investing, including:
- Limited investment options
- Fewer short-term gains
- No above-market returns
Assessing your risk tolerance and profile
Knowing your tolerance for risk is key to determining the right investment strategy for you. Any type of investing has risks, of course, including the risk that you could lose money. But you can determine what you’re comfortable with by determining your risk profile. Depending on your age, income, time horizon, and financial goals, you’ll likely fall into one of these categories:
- Conservative: You might be focused on stability, even if it means smaller gains.
- Moderate: You’re probably looking for long-term growth potential, but you still want some amount of stability.
- Aggressive: You may want to maximize your gains in the long run, even if it means sacrificing stability in the short term.
Discovering your investing approach
While investing strategies are flexible, it’s best to understand the overall investing approach that may work best for you before diving in. It could be passive management of your investments, active management, or a combination of both. It all depends on how much hands-on involvement you want and how much risk you’re willing to take with your investments. The good news is that if you choose one approach and it doesn’t work for your risk tolerance or time horizon, you can switch it up.
Passive investing is often focused on building wealth for the future, such as in retirement. These calculators can help you identify your long-term growth goals and how to get there:
- How much money you need to retire
- How much your investments could grow through compounding
Combined with your risk profile, those numbers can give you an idea of how much to invest and what strategy makes the most sense for you.
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I'm a seasoned financial expert with a deep understanding of investment strategies, particularly in the realm of passive investing. My expertise extends to the intricacies of index funds, ETFs, and the historical context behind the development of passive investing. Allow me to delve into the concepts covered in the article you provided:
Passive Investing Overview: Passive investing, also known as a buy-and-hold strategy, aims to build wealth gradually by buying securities and holding them long-term. The strategy avoids frequent trading to minimize fees and risks. It relies on the belief that the market will yield positive returns over time, emphasizing time in the market over timing the market.
Index Funds and ETFs: Index funds, pioneered by Jack Bogle in 1975, are a crucial element of passive investing. These funds, including mutual funds and ETFs, mimic the performance of market indexes. They allow retail investors to compete with professionals, marking a revolutionary addition to the market. While mutual funds were initially prevalent, ETFs have become the most common type of passive fund.
Active vs. Passive Investing: Active investing involves a hands-on approach, aiming to "beat" or "time" the stock market. It is riskier, requires frequent portfolio management, and often incurs higher fees. Passive investing, in contrast, is a long-term, less frequent buying and selling strategy. It emphasizes a diversified portfolio, adopting a "buy and hold" mentality, resulting in lower risk and cost-effectiveness.
Passive Investing Strategies: Passive strategies leverage passively managed mutual funds and ETFs due to their built-in diversification. Index funds, such as those mimicking the S&P 500, are well-suited for passive investing. ETFs, being tradable on stock exchanges, provide additional flexibility.
Pros and Cons of Passive Investing: Pros include low maintenance, tax efficiency, diversified investments, lower fees, and steadier returns. However, cons may arise for investors seeking large short-term gains, as passive investing limits opportunities for quick buy-and-sell maneuvers.
Assessing Risk Tolerance: Determining risk tolerance is crucial in choosing an investment strategy. Conservative, moderate, and aggressive profiles guide investors based on their preferences for stability, long-term growth, or maximizing gains, respectively.
Choosing an Investing Approach: Investors should understand their risk tolerance, time horizon, and financial goals to choose between passive and active management. Flexibility is key, allowing investors to switch strategies based on their evolving preferences and circ*mstances.
In conclusion, passive investing is a strategic approach focused on building wealth for the future, particularly in retirement. Stash, as mentioned in the article, facilitates easy entry into passive investing with its Smart Portfolio customized to individual risk profiles, time horizons, and budgets.
