What is passive investing?

The investment strategy you choose today is critical to your long-term success. Some believe that stock selection and market timing – also known as active investing – is the right approach. Others believe that investing broadly, managing risk, and keeping fees and taxes as low as possible – a passive approach – is better.

The only thing that really matters is which strategy will work for you. Here’s what you need to know about both strategies, and why passive investing may be your key to better investment outcomes.

What is passive investing?

Passive investing is a strategy that focuses on having a long-term investment outlook and remaining invested through the ups and downs of the markets and the economy. It’s often referred to as a buy-and-hold approach because it’s a strategy that aims to minimize the buying and selling of investments in response to market conditions.

The goal of passive investing is to participate in, or mirror, the returns of the markets, not to try and beat them. It’s the idea that stock selection and market timing don’t work and that investors should invest broadly to reduce risk, keep fees as low as possible, minimize taxes, and make changes only when it makes sense for their financial plans. Focusing on what you can control and ignoring what you can’t – like the markets, the economy, interest rates, or inflation – will lead to better returns and outcomes.

Types of passive investments

There are two prominent ways to be a passive investor, and both approaches are designed to track what is called an index.

An index is a way to categorize and track a group of stocks or bonds with similar characteristics.

For example, the largest 500 companies in the United States are tracked via the S&P 500 index. This is why you may hear passive investing referred to as index investing.

Here are the two passive investments you need to know:

1. An index mutual fund 

Individual investors put their money into a fund – a larger pool of money - and that fund invests in the stocks or bonds that track a particular index either in the U.S. or overseas.

2. An exchange-traded fund (ETF)

An ETF is similar to a mutual fund in that it invests broadly across stocks and bonds based on a selected index. The main difference is that ETFs can be bought or sold throughout the day, like stocks, whereas mutual funds can only be bought or sold once per day (after markets close).

Pros and cons of passive investing

Passive investing has both pros and cons depending on the type of investor you are. Here’s a look at both:

The Pros:

Diversification

Passive investments allocate money broadly to many stocks or bonds as measured by the index it tracks instead of one, or a few, companies.

Lower risk

Diversification comes with lower risk. Investing across many companies means you aren’t subject to the risk of any one company failing.

Lower costs

Because passive investments don’t rely on market forecasts, company research, or active trading, their costs are incredibly low and often a fraction of the cost of active investments.

Lower taxes

Since passive investments take more of a buy-and-hold approach and aren’t actively buying and selling stocks, they don’t generate a lot of taxes which means you pay less over time.

The Cons:

Less flexibility

Because passive investments own a wide array of stocks or bonds, you have to own every company in the index and can’t hand select or drop any particular company.

Market returns

For investors that believe in active management, passive investments will only generate returns that mirror the market. They will never beat market returns.

Active vs. passive investing: Differences and performance

The counterpart to a passive investment approach is an active approach. Active investors are individuals or larger institutions, like investment companies and Wall Street firms, that believe stock selection and market timing can produce returns that are greater than the broader market such as the S&P 500. 

Active investors do research on individual companies and try to forecast and predict changes to the economy, interest rates, inflation, and other indicators to gain an edge. In short, they are actively buying and selling investments based upon their forecasts.

So does active or passive investing provide better investment outcomes?

To some, active management can sound like a winning strategy. Who wouldn’t want to buy the winners and avoid the losers?

Unfortunately, market timing and stock selection strategies fail to provide the investment returns that many seek. In fact, the majority of professional money managers that actively trade stocks or bonds fail to generate returns that are better than the index that they are trying to beat.

Source: SPIVA® index versus active scorecard as of 6/30/2021

Even when active managers do outperform, those periods of excess returns are short lived* making it very difficult to not only pick the best managers but to find the ones that consistently outperform over time. If you’re wrong, it can be a very costly mistake.

The bottom line is that active investments fail to outperform, charge high fees – often 0.50% to 1% or higher – and create higher taxes. It’s a bad combination that leads to your returns being lower than you think.

On the other hand, passive investments mirror market returns, help you create a well-diversified portfolio, better manage risk, come with very low fees, and minimize taxes. This is why passive investing can be a great solution for most people looking to participate in market returns, grow their money, and keep more of it working for them over time. Remember, it’s not just how much you make, it’s how much you keep.

Final word

What most people get wrong about investing is that they believe their investment strategy alone is the key to better returns and outcomes. The truth is that any investment strategy, passive or active, developed in isolation of a financial plan to guide it will fail.

Having a plan to guide your strategy will help you make critical decisions over time including how much to invest, what account types to use, what investments to own, how much risk to take, and how to minimize fees and manage taxes. Passive investing is simply a tool, albeit a powerful one, to help you execute that strategy.