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 exchange-traded funds (ETFs).
- Passive investing allows you to secure a great base of stock exposure in your portfolio.
What is Passive Investing?
Passive investing is an investment strategy that tries to maximize investment returns while minimizing investment fees. This investment strategy chooses not to engage in frequent trading of stocks but instead adopts a more buy-and-hold long-term oriented investing strategy.
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. Investors can invest in an ETF, which is an investment security that represents 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 and make 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 having to buy each stock in an index, you can purchase an index fund, which is 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, and 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 do not try and 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 in their actual investments. Passive investment funds like index investing and ETFs are very clear about where they are investing. This gives you more power when making an investment decision.
Tax Advantages: Because you are adopting a buy-and-hold philosophy to 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 appreciate. This is opposed to the tax implications of actively managed mutual funds and ETFs where even if you haven’t sold any shares, if the fund has realized a gain from buying and selling a security, you may owe taxes.
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 replicates 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 gives you the ability 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 to comprehend. Active investing is generally more complicated than passive investing and presents many opportunities to make money by investing too.
There is no time like the present. Make sure you have saved enough money to have discretionary income to start investing. How much and how often you invest is tethered to your current financial health. The less debt you have and the more income you make, the faster you can start growing your money quickly through investing.
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