Passive investing: What is it and is it a better option than active investing?

The question we’re looking at in this article is: how does passive investing compare to active investing? We look at what passive investing is, how it differs from active investing and whether or not it generates returns for investors.

What is passive investing?

Passive investing is a long-term investment strategy in which investors seek to grow their money over time with minimal effort and cost. The goal of passive investing is to buy and hold investments for the long-term with minimal trading activity, thereby reducing the amount of fees paid on transactions.

How does this work in practice? Investors construct a portfolio that seeks to replicate the performance of a market index (like the ASX 200), by replicating the indice exactly, and thus matching rather than beating it. And so investors will buy and hold for the long-term.

With passive investing, investors have the potential to benefit from long-term fundamental market growth while minimising expenses such as trading fees and capital gains taxes that come with share transactions. But in doing so, they may miss out on growth opportunities that they would obtain with active investing – the opposite of passive investing.

Active investing is buying and selling investments, attempting to beat average market return. Again, this can be done in several ways. It might be by using a money manager that tries to beat the market or by building a portfolio of high-growth stocks.

What are the advantages and disadvantages of passive investing?

There are three key advantages of passive investing. The first is the lower fees as a result of less frequent trading and lower management costs compared to active management. The second is the simplicity of investing. There tends to be fewer decisions to make, as the strategy is generally about sticking to a predefined index or asset allocation. And thirdly, passive investing has delivered returns similar to the market, which over time can be (and has been) substantial.

There are two key disadvantages. The first is that passive investors are unlikely to beat the market because they are essentially tracking it. The second is that they are missing out on opportunities outside the indice where substantial returns can be made. And thirdly, since the goal is to track the market, passive investors are exposed to the same downturns and volatility as the market.

How to be a passive investor

In today’s world, there are several different ways for investors to access passive investments or be passive investors. Generally, passive investors diversify their portfolio by investing in a variety of stocks, bonds and other asset classes to reduce risk.

Index funds and exchange-traded funds (ETFs) are two popular forms of passive investing vehicles that offer investors access to a variety of assets. These funds allow investors to diversify their portfolios without the need to pick individual stocks or bonds.

One particular option is to look to ETFs that track a market indice and will likely deliver the same returns as the index. Additionally, robo-advisors are software programs that provide automated asset allocation advice and portfolio management services for a low fee. Robo-advisors make it easier for investors who may not have the time or knowledge to build and manage their own portfolio.

Does passive investing work?

This is a difficult question to answer in practice. But according to Morningstar, it does. In the last 10 years, only 25% of active funds beat passive funds. Keep in mind this only measures fund managers rather than individual retail investors. There are active investors out there who haven’t done as well as passive investors and vise versa. But whatever way you choose, it will all depend on the stocks you choose to buy and the growth they deliver in the longer-term.

Passive investing can be a great way for investors to build wealth over the long-term while reducing risk and minimising expenses. With passive investments, investors have the potential to benefit from market growth over time with minimal effort or cost. Passive investors may miss out on high-growth opportunities but still access some growth but without the risk that comes with higher-growth companies.

By diversifying their portfolio and picking the right companies, passive investors can be well on their way to achieving financial success.

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