“For women, financial independence is a matter of necessity.” ― Carrie Schwab-Pomerantz, board chair and president of Charles Schwab Foundation
There are many paths to financial freedom and wealth building but almost always investing is part of a successful financial plan. There are as many approaches and opinions on investing as there are investors. Some people prefer active investing while others are more comfortable with passive management. If you’re new to investing it’s important to know the different investing options available to you to be able to devise a good investment strategy for yourself. In this article you’ll learn all about passive investing and how you can make the most of this investment strategy.
What is passive investing?
Passive Investing is essentially putting your money to work for you instead of you working for it. Passing investing, also known as passive management, as an investment strategy focuses on buying and holding investments for a longer time period instead of trying to beat the market. It minimizes frequent buying and selling therefore avoiding the losses associated with frequent trading. The main difference from active investment strategies is that passive investing involves building wealth slowly over time.
With a passive approach you can invest in stocks, bonds, funds, and other assets that bring passive income through dividends, interest, or rent. Considered a reliable strategy by long term investors, passive investing takes advantage of the overall upward market trend over a long term. It uses market-weighted indexes and portfolios, minimizes trading, reduces transaction costs, and avoids many of the fees that come with active investing.
Passive investing is based on the philosophy of “buy-and-hold”. The strategy is based on the idea that a low cost well diversified portfolio is likely to bring an average market return where active investing is about frequent transactions to achieve above-average returns. Therefore passive investors pursue investing in securities that grow over a long period. Instead of trying to beat the market, they put faith in steady market increases. Overall, compared to active strategies passive investing is simpler, cheaper, and leads to better after-tax returns over a long term.
Types of passive investment/ Passive investing options
Passive investment portfolios can be diversified and include a number of different types of investments but commonly include mutual funds, exchange traded funds (ETFs), and index funds. These types of funds diversify your investment over a number of individual holdings.
Index funds: With index funds you can track specific individual investments within the index fund. Popular index funds include Vanguard Growth Index and Fidelity 500 Index beside gold and oil funds.
Mutual funds: Mutual funds are about professional management with a focus on diversification. When you invest in mutual funds, the company buys and sells stocks and bonds on your behalf. Companies manage investments directly or through a brokerage firm. Commonly mutual funds apply a penalty of upto 1% of share value on selling early.
Exchange Traded Funds: Like mutual funds, ETFs also trade on an exchange. They can either invest in a group of stocks or an index like the S&P500 or the MSCI indexes. ETFs don’t have fixed minimum holding period and don’t have high fees like mutual funds, making them more cost effective. Both mutual funds and ETFs include portfolios of bonds, stocks, precious metals, and other assets.
Warren Buffet, a passive investor himself recommends,
“Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund.”
Real estate: Real estate investments can also make for stable passive investments. You can hold them for a long period of time while receiving benefits from renting out the property.
A passive investment strategy follows a set of fundamental principles.
- Invest in a collection of long-term holdings, diversified across industries, market sizes, and geographical areas.
- Do not sell your holdings early under any circumstances.
- Continue to invest more into your funds or brokerage account by reinvesting the dividends.
- Keep costs and fees minimum.
Benefits of passive investing
- Low costs:
Index funds monitor a target benchmark instead of following individual winners. Minimal trading results in lower operating costs and fees.
- Low risk:
With index funds risk is spread more broadly in holding a large sample of securities. Passive investing offers a more secure way of investing as it follows the market which grows over time so there’s less chance of losing your assets.
- Transparent:
Passive investors have clear knowledge on their assets.
- Tax efficient:
- Passive strategy of holding out the assets for a longer period of time results in slow but steady growth over the years. This saves passive investors from huge capital gains tax per year.
- Less complex:
Passive investing through index funds is much simpler to understand and apply as compared to devising an active investment strategy which requires continued research, monitoring, and adjustments.
Drawbacks of passive investing
Just like every investment strategy, passive investing has its pros and cons. One drawback of passive investing is that it is limited to a certain index or set of investments with little variation. Investors are bound to these holdings over a long period of time through the ups and downs. The downside of the low risk passive investment is that there are smaller potential returns on investment. It cannot match the huge returns often achieved through active management.
Is passive investing the right option for you?
Investors have different personalities and varying preferences. One strategy does not suit all when it comes to investing. Passive investing can suit you if you are busy and don’t want to spend a lot of time on monitoring your investments and managing your assets. It can be a great idea if you have long term financial objectives and are not seeking urgent returns. For example passive investment can help you save for retirement or build your child’s college fund.
Another important characteristic for passive investors is patience. Passive management can work for you if you have the patience to let your assets for a long period without interfering. If you don’t want to try anything risky and desire a safe way to invest for your long term future, passive investing is ideal for you as it offers greater security with steady growth. Index funds can offer a hands-off approach where investment professionals manage the funds for you. Passive investing has gained popularity over the years. Although it offers a slower growth rate overall performance of passive investing matches that of active management. Passive investing offers a safer alternative to people who seek security and don’t want to play the market.
On the other hand passive investing may not be the right option for you if you want more discretion and control over your portfolio. With passive investing fund managers control the majority of funds and investment decisions. As a result passive investors are less involved in managing their investments. So if you seek more control and flexibility a more active approach to investment may be more suitable for you.
If you do decide to try passive investing, remember to stay in it for the long run. Don’t get discouraged by unexpected dips or too excited about jumps. Passive investing calls for far sight, patience, and a bigger vision. Once you make your investment, sit back and trust that your money will work for you because it is the safest investment with lowest risk. Building wealth takes careful planning, time, and patience but the returns are always worth the effort.
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson
