Takeaways
- Beginner and seasoned investors can enhance their portfolios with passive investments.
- Passive investing adopts a hands-off investment strategy that focuses on long-term horizons.
- Passive investing looks to maximize investment returns and minimize fund expenses.
- Common types of passive investments include index funds and ETFs.
- Passive investing allows you to secure a great base of stock exposure in your portfolio.
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What is Passive Investing?
Passive investing is an investment strategy that maximizes investment returns while minimizing investment fees. This strategy does not engage in frequent stock trading but instead adopts a more buy-and-hold, long-term oriented approach.
The goal of passive investing is to get rich slowly. Passive investing money managers tend to believe that the market or sectors of the economy will increase in value over time and that by investing in a diversified index, you can earn income through capital appreciation.
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Passive investing is used in index investing, where investors invest in an index constructed to represent a particular element of the market or mirror a specific index, such as the S&P 500 Index. Other index investing aims to mirror segments of the economy, such as large capitalization companies, while others track leading stock indexes like the Dow Jones Industrial Average, NASDAQ, or S&P 500.
Exchange-traded funds, or ETFs, can also be securities for passive investing. An ETF is an investment security representing an investment in a basket of securities. ETFs can also invest in and track a sector, industry, or index. ETFs are bought and sold like stocks, making passive investing accessible to many new investors.
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Advantages of Passive Investing
- Diversification: Investing in a passive investment fund exposes your portfolio to a wide range of stocks for a fraction of the historical cost. Instead of buying each stock in an index, you can purchase an index fund, a pool of capital that has already been benchmarked against the index. This allows your portfolio to gain investment diversification at a fraction of the cost, which is why passive investing has boomed over the last several decades.
- Low Fees: Passive investment funds such as index investing try to minimize constantly selling and buying stock to avoid high fees and operating expenses. Thus, passive investment funds, such as index funds, try to keep their fees low by simply tracking an index and not trying to constantly find the hot stock. By investing in an index fund, which replicates the performance of a particular index, there is not as much portfolio turnover as an actively managed fund. This reduces fees in the long run.
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- Fund Transparency: Certain investment funds can be opaque about their actual investments. Passive investment funds, like index investing and ETFs, are very clear about where they are investing, which gives investors more power when making an investment decision.
- Tax Advantages: Because you adopt a buy-and-hold philosophy when investing, you don’t have to worry about dealing with capital gains tax every year. After you sell your index fund investment, for example, you will have to worry about taxes, but there is no annual commitment to pay taxes while your investments are appreciated. This is opposed to the tax implications of actively managed mutual funds and ETFs, where you may owe taxes even if you haven’t sold any shares if the fund has realized a gain from buying and selling a security.
- Simplicity: For the beginner investor, passive investing can be a perfect strategy to get started investing. Because this investment strategy involves much less research than a more active strategy, it can be easier to comprehend and implement.
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Disadvantages of Passive Investing
- Potentially Lower Returns: Passive funds are not created to beat the market. They are designed, for the most part, to reflect their holdings in bull markets and bear markets. During boom times, your holdings will reflect the overall performances of a group of stocks if you are index investing. Conversely, when the market is facing a time of turmoil, your investment performance will closely emulate the broader market downturn.
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Active investment managers promise the allure of beating market returns. They want to inject alpha, or above-market performance, into their actively managed portfolios. These managers must do much more research to select the best stocks and investments available. Because of this, active managers charge a higher investment fee than passive fund managers. This active approach inherently ushers in more investment risk. Investors in passive investments gladly trade lower-risk positions for more limited upside returns.
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- Fixed Investment: The investment strategy adopted by passive investment funds is to identify a group of investments that effectively replicate a particular index, sector, or industry. Once this predetermined set of investments is solidified, investors are essentially cemented into these holdings. That is what allows the index or fund to match the machinations of the target holding. There are few exit opportunities unless you choose to sell your index or ETF holdings to avoid market downturns.
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Smart Summary
Passive investing offers investors access to a wide range of investments. Passive investing allows you to significantly diversify your portfolio at a fraction of the historical cost. The benefit is that you can also buy in and out of index funds or ETFs as your portfolio evolves. Consult with a financial advisor and robo-advisor to see how passive investing could help your portfolio.
Frequently Asked Questions
Investing in passive investments should be considered by beginner investors and investors looking to add less speculation into their investment portfolio.
Not necessarily. Passive investing offers many benefits, like low fees, transparency, and simple strategies. Active investing is generally more complicated than passive investing and presents many opportunities to make money, too.
How much and how often you invest is tethered to your current financial health. The less debt you have and the higher your discretionary income, the faster you can start growing your money quickly through investing. The key is to take advantage of compounding interest.
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