Passive investing is an investment strategy that seeks to build wealth over the long term. Instead of frequently buying and selling investments based on their short-term performance, passive investors buy and hold investments for the long-term, typically seeking to match the returns of a specific broad-based market index or benchmark.
This article will help explain the pros and cons of passive investing, how it compares with active investing, and how a passive investment strategy may help you build wealth and achieve your financial goals.
What is Passive Investing?
Passive investing is a long-term investment strategy that focuses on buying and holding investments for the long term. Its goal is to build wealth gradually over time by buying and holding a diverse portfolio of investments and relying on the market to provide positive returns over time. Instead of frequently buying and selling investments to try and beat the market, a passive investor seeks to buy and hold a portfolio of investments that may steadily increase in value over time, based on historical market returns.
The most common type of passive investing is index investing, where investors seek to invest in a portfolio of stocks, bonds or other assets that mimic the composition of a particular market index.
Passive investing has become an increasingly popular investment strategy and may help investors build wealth and achieve their long-term financial goals.
What is Active Investing and how does it differ from Passive Investing?
Active investing is the opposite of passive investing. Passive investors try to mimic market returns, while active investors try to beat market returns. Active investing involves actively searching for and investing in securities with the goal of exceeding market returns.
Active vs Passive Investing
Different active investing strategies will have different investment objectives and goals. A common goal of active investing is to seek to beat market returns or market-like returns at lower level of volatility, while the typical goal of passive investing strategies is to seek to duplicate the returns of a market index or other benchmark.
Active investing strategies usually involve actively researching, building, and adapting a portfolio to achieve an investment objective. Passive investing usually involves building a portfolio that seeks to mirror a market index or other benchmark.
Passive investing, and investing in passively managed funds, is typically cheaper than active investing. As this strategy tends to involve less buying and selling of investments, it can reduce transaction costs and management fees, which are often higher for actively managed funds.
However, passive investing typically involves buying and holding investments for the long term, which may limit the ability of an investor to make short-term changes to their portfolio in response to changing market conditions.
Active Funds vs Passive Funds
Active funds are investment funds managed by investment professionals who seek to identify investments that they believe will help the fund achieve a particular investment objective. The investment objective may be to outperform a particular benchmark, but it could also be some other goal such as to provide market-like returns with lower levels of volatility, higher risk-weighted returns, returns over a particular time horizon, etc.
Passive funds, on the other hand, are funds that replicate a market index and emulate the index composition. While both active and passive funds have portfolio managers making final investment decisions, the key difference is in the different investment objectives, where passive funds have a much simpler strategy that is generally much cheaper to implement and manage. Actively managed funds involve higher transaction costs and fees due to extensive time and effort invested by professional fund managers in pursuit of the desired objective, which can lower returns for investors. Some actively managed funds may also have investment objectives that carry greater risk than passively managed funds.
Passive funds are often automated, with limited human management. However, as passive funds are linked to a specific index or benchmark, they tend to rise and fall along with the benchmark. Hence, passive portfolios require periodic rebalancing to keep them aligned with the index/benchmark.
Active and passive investing are both recognized investment strategies used by investors to seek to build wealth and achieve their financial goals. Which strategy may be best for you will depend on a number of factors.
Things to consider when choosing between active vs passive investing
Particular investment strategies should be evaluated against an investor's objectives, risk tolerance, and other considerations. Some of the factors to consider may include:
- Risk appetite: Active investing generally requires higher engagement and risk tolerance as it depends on short-term moves and market can swing in any direction. Passive investing seeks to reduce risk by investing in a diverse portfolio of investments that mimics the composition of a market index or other benchmark, believing that market values will grow over time and provide reliable returns for investors.
- Cost/ fees: Active investing typically costs more than passive investing. That’s because frequent trading and management in an individual portfolio will typically result in higher trading costs.
- Time commitment: Active investing demands much more time commitment than passive investing, as it requires investors to stay informed about the market trends and actively manage or adjust their portfolio to meet desired short-term objectives. Passive Investing is generally sought by investors with less experience and/or those working towards a long-term goal.
Depending on their specific investment objectives, some investors may choose to invest in a combination of actively and passively managed funds.
