Passive Investing (What It Is And Why It’s Important)

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What Is Passive Investing

Passive investing is a type of investment strategy where the investor’s objective is to invest in a particular investment instrument, hold it long-term, and minimize buy and sell transactions.

In other words, a trader, investor, or individual adopting a passive investing approach looks to buy and hold his or her investment on a long-term basis.

One common investment instrument used to passively invest is to purchase index funds like the S&P 500 as an example.

Buying an index investment instrument allows you to buy into a variety of stocks in different industries allowing you to benefit from a certain level of risk diversification.

The main advantage of investing passively is that the transactional costs to the investor are going to be much lower than active investing.

Fundamentally, passive investors and passive investment managers invest in such a way as to replace the market performance or the performance of a certain sector.

The reason for that is that their objective is not to out smart the market but to earn a profit that is representative of what the market average provides.

Passive Investing Definition

According to Investopedia, passive investing is defined as follows:

As you can see from this definition, here are the characteristics of passive investing:

• Your goal is to limit trading fees 
• Your objective is to buy an investment and hold it for a long time 

Passive Investing Strategy

A passive investing strategy is a type of investment strategy where the investor or trader is looking to purchase a particular investment instrument and make money by keeping it for a long time.

With this strategy, the trader does not incur an important trading fee resulting from the buying and selling of investments.

Also, by keeping the investment for a longer period of time, the investor hedges against the short-term fluctuations and volatility of the market.

In other words, the market timing to purchase the investment will not be as crucial as the market timing for an active investor whose goal is to buy at a low price and sell quickly at a higher price.

The main premise underlying passive investment strategies is based on the fact that over time, the prices will go up and the investor will earn a profit.

A good investing strategy that is passive in nature is one where the investor builds a well-diversified portfolio of different stocks that represent a sector or the market.

If you do not want to purchase and hold individual stocks, you can purchase exchange-traded funds or ETFs allowing you to track major indices and trade them as of they were individuals stocks (this is called passive index investing).

Passive Investing Advantages

Adopting a passive investing strategy to build wealth and earn profits over a long period of time has several advantages that you should consider.

One of the most important advantages to invest passively is to ensure the reduction of investment risk and the diversification of your investment portfolio.

If you invest via indexing, you are investing in an instrument that acts as a benchmark of the market or a sector.

This means that you are investing in an entire market sector or the entire market in general giving you a much greater level of diversification where you are spreading your risk broadly.

If a few stocks go down in the market, your risk will probably get offset by a few stocks going up.

Overall, your return will be the average market return representing the overall result of the performance of each stock within a sector or in the market.

A second advantage of passive investing index funds is that your transactional costs are going to be kept low.

Since your aim is to buy once and hold it for the long term, you are not exposed to having to pay trading fees repeatedly.

A third advantage is that the investment strategy is actually quite simple.

All you have to do is to buy an index or several single stocks in your passive investing portfolio and hold on to it until they appreciate in value.

Passive Investing Disadvantages

Although you can expect benefits from passive investing, you should also consider its drawbacks.

One notable drawback of passive index fund investing is that your investment is tied to the overall market risk or total market risk.

In other words, if the market prices fall or the market collapses, your portfolio value will also collapse. 

Since your investment approach is to mimic the market returns, you are also exposed to market risks no matter how well diversified you are.

A second drawback in passive investing is that you have less flexibility in controlling your risk when market prices go down.

For instance, index fund managers are typically prohibited from adopting defensive investment strategies in an attempt to preserve portfolio value when market prices are going down.

This means that if the market goes down, the value of your shares in the index fund is inevitably going to go down as well.

Although this sounds counter-intuitive, it actually has a proper investment foundation.

Don’t forget that index funds are designed to provide the investor a return consistent with the market.

This means that if the market goes up, the value of the index fund goes up.

However, if the market goes down, the value of the index fund will go down as well since the index fund’s primary objective is to mimic market returns and not to beat the market.

Characteristics of Passive Index Investing

What are the characteristics of passive investing?

Overall, here are the characteristics of investing in a passive manner:

• You incur less trading fees 
• You know exactly what assets you are holding 
• You are more efficient from a tax perspective 
• Your investment strategy is simple 
• You have diversified holdings 
• You have an overall optimistic outlook on the market performance 
• You take less risk 
• You have less control over your investment performance 
• You may achieve a return slightly lower than the market return 
• You have less flexibility in your investment strategy 
• You can’t hedge as well as an active investment strategy 

The best example of passive investing is the investment in index funds such as the S&P 500, Dow Jones Industrial Average (DJIA), or similar ones.

These indices hold stocks that are representative of the market or a sector.

Typically, when the indices invest in a new stock or remove a particular stock from their holdings, investors looking to follow the indices will also switch up the content of their portfolio to match that of the index.

Active Investing 

What is the difference between passive investing and active investing?

Actually, passive investing is the opposite of active investing.

Active investing is a more aggressive type of investment strategy where the investor or trader is looking to beat the market performance.

In other words, an active investor wants to earn a profit that will be higher than the market returns by taking advantage of price fluctuations in stocks, bonds, or other instruments.

Active traders are much more knowledgeable in investing and the markets than passive investors.

In general, an active investor will perform a deep analysis of the different stocks, bonds, or other investment assets to consider their potential risks and rewards.

One main driver of performance and return for active investors is market timing.

If you buy a stock or security at the right time (and at the right price), then sell it at the right time (and at the right price), you will make a profit.

Another characteristic of active investing is that the investor is hands-on.

If there is an opportunity to make money in the short term, the investor will seize the opportunity.

“Passive Investing” Takeaways 

So, what does passive investing mean?

What are some passive interesting strategies?

What is index fund investing?

Let’s look at a summary of our findings.

What Does Passive Investing Mean

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