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How a Passive Investing Strategy Works

Passive investing – also referred to as passive management – is an investing strategy that involves buying and holding investments for a long period of time, rather than making frequent trades to try to beat the market. It is a go-to strategy for long-term investors, because it capitalizes on the typical upward trend of the overall market over many years. By minimizing trades, it also ensures that transaction costs are as low as possible.

Want to use a passive investment approach for your portfolio? Consider speaking with a financial advisor in your area.

What Is Passive Investing?

Passive investing, which is also sometimes referred to as passive management, is best categorized as a “buy and hold” philosophy. At its core, it’s a straightforward investment approach that looks to avoid frequent buying and selling, and seeks to invest in securities likely to grow over the long term. Consequently, passive investors are betting on steady market increases rather than trying to beat the market. This is in direct opposition to active management, which call for frequent transactions in an effort to achieve above-average returns.

Passive portfolios typically include a few different types of investments. Principal among these are index funds, mutual funds and exchange-traded funds (ETFs). Rather than select single securities like stocks or bonds, these funds seek to diversify across a number of individual holdings. As an example, a fund centered around stocks might invest in multiple equities in specific markets, like large-cap U.S. stocks or the international market. Here’s a deeper breakdown of these investments:

  • Mutual funds: When you buy into one of these funds, you’re investing in a company that will buy and sell stocks, bonds and more in your name. In other words, mutual funds combine professional management and diversification.
  • Exchange-traded funds: While similar to mutual funds in many ways, ETFs are traded on an exchange like a stock. They follow a collection of stocks or an index (such as the S&P 500, the MSCI Indexes and the Dow Jones Industrial Average). While ETFs can take a variety of investing approaches, they’re a bit more likely than a mutual fund to take a passive investing approach.
  • Index funds: An index fund can be a mutual fund or ETF; either way, your investment will track the performance of an index. This has led many individual investors to consider adding index funds to their portfolio over ETFs. Fidelity and Vanguard claim some of the more popular index funds, such as the Vanguard Growth Index (VIGRX) and the Fidelity 500 Index (FXAIX).

Pros and Cons of Passive Investing

How a Passive Investing Strategy Works

Every investment strategy has its strengths and weaknesses, and passive investing is no different. For those who have no reason to hop into anything risky, passive management provides about as much security as can be expected. Because passive investments tend to follow the market, which tends to experience steady growth over time, the chance you’ll lose your invested assets is low in the long run.

One of the main tenets of passive investing is the maintenance of long-term holdings. Because there’s very infrequent buying and selling, fees are low. In short, this means you’ll lose less of your returns to management.

ETFs and mutual funds are staples of passive investing portfolios. They all also have a couple characteristics in common: professional management and inherent diversification. When you invest in stocks, bonds or any other security on a singular basis, it’s up to you to choose which ones you want and when to buy and sell them. But because investment professionals manage the aforementioned trio of funds, you’ll reap the rewards of strong diversification and asset allocations without getting your hands dirty. Choosing an index mutual fund or ETF results in a particularly hands-off approach.

For investors who want complete discretion over their portfolio, passive investment may not be the best option. Passive portfolios usually contain a majority of funds that are under the jurisdiction of fund managers. So while the overall performance of these funds dictates your eventual returns, the investment decisions are not under your control. Thus, this lack of customization and flexibility could leave passive investors feeling like they’re not involved enough in the overall management of their money.

Of course, unless you know what you’re doing, managing your own investments can be tricky. As a matter of fact, even the most “intelligent” investors will endure significant struggles. However risky as it may be, passive investing technically has less return upside than strategies that look to beat the market through stock-picking and recurring trades. In return for this trade-off, though, passive investors regularly see slow and sustained growth.

Passive vs. Active Management

Passive investing and active management are polar opposites. Active investors prefer consistent trading in line with market trends. By contrast, passive investors ride the market for years at a time. It’s important to note that if you’re involved in this debate, there’s really no perfect answer as to whether either of these strategies is intrinsically better. Instead, each investor’s individual circumstances will shed light on which is the more beneficial choice for them.

What this decision ultimately comes down to is your risk tolerance, which is your ability to stomach volatility in the hopes of higher returns. While no equity-focused investment approach can be called safe, a portfolio more focused on matching market returns is safer than one seeking to “beat” or “time” the market. On the other hand, if risky investing is within your means, an active portfolio could be more fitting.

Your investment goals are another deciding factor for which style of management is preferable. For example, let’s say there’s a 25-year-old who wants to buy a home over the next few years and a 30-year-old who’s saving for retirement. The investments they should make are drastically different. Because the future homeowner is closing in on his or her goal, he or she might consider high-risk, high-reward investments. Retirement is far away for the 30-year-old, though, allowing this person to stick to passive investing if he or she so chooses.

If you want an actively-managed portfolio, know that you will encounter more fees than a passive investor will. Because active management calls for consistent trades to beat the market, you’ll likely spend a significant amount in transaction fees. Passive investors prefer to buy and hold securities, lowering their extraneous costs in the process.

Bottom Line

How a Passive Investing Strategy Works

Because passive investing is an innately long-term approach, it’s best for those with long-term financial objectives. For instance, passive investors might be saving up for retirement or for their child’s college education.

Before investing any money in the market, you should take some time to learn about the strategies available to you. That includes passive investing. Similar to many other financial topics, education is invaluable. So although passive investing has many perks, that doesn’t mean it’s the right strategy for everyone.

Investing Tips

  • Many financial advisors utilize passive investing as their main investment strategy. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • For those that have less money to invest, robo-advisors are a great alternative to more expensive financial advisors. In fact, many robos already incorporate plenty of index funds, ETFs and mutual funds in their portfolios. As a result, passive investing is a major centerpiece in the robo-advisor community.

Photo credit: ©iStock.com/Jay_Zynism, ©iStock.com/Foryou13, ©iStock.com/MicroStockHub

Chris Thompson, CEPF® Chris Thompson is a retirement, savings, mortgage and credit card expert at SmartAsset. He has reviewed hundreds of credit cards and loves helping people find the one that best matches their financial needs. Chris is a Certified Educator in Personal Finance® (CEPF®) and a member of the Society for Advancing Business Editing and Writing. He graduated from Montclair State University where he received the Journalism Achievement Award. Chris’ articles have been featured in places like Yahoo Finance, MSN and Bleacher Report. He lives in New Jersey and is a Mets, Jets and Nets fan.
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