Passive investing strategies seek to maximise investment returns by trading as little as possible. Instead of actively buying and selling securities, passive investors adopt a buy-and-hold approach. And for those not interested in learning how to pick stocks for the long term, index investing is one of the most popular passive investing strategies.
Characteristics of passive investing strategies
At the heart of every passive investing strategy lies the investment goal of building wealth steadily over time while ignoring short-term opportunities. There are some differences between the various methods available. However, some common characteristics across all forms include:
- Long-Term Outlook – Passive investors seek to capitalise on the long-term upward trend of the stock market. Therefore, they operate with long investment time horizons.
- Diversified Portfolio – While the stock market generally trends upwards over time, not every business survives the journey. Therefore, a portfolio needs to be well diversified to absorb and mitigate the damage of one or more positions failing to meet expectations. Index funds are incredibly popular among passive investors since they provide instant diversification within a single transaction.
- Lower Risk Profile – While it’s impossible to eliminate all investment risks, the potential adverse impact of firm-specific threats can be mitigated through diversification. Therefore, passive investors are typically exposed to a lower risk profile than active investors.
- Low Costs – The buy-and-hold philosophy of passive investors results in far fewer transactions versus an active trader. As such, the amount of money spent on commissions and transaction fees is significantly lower. Furthermore, long-term investments are taxed less than short-term trades in some countries, resulting in additional tax savings.
- Dividends – While not a requirement, stocks popular with passive investors often provide a stream of passive income through dividends.
Types of passive investments
Several types of securities and tools are available for investors to adopt passive investing strategies.
- Index Fund – As previously mentioned, index funds are one of the most popular passive wealth-building methods.Investors can buy shares in a low-cost passive mutual fund or an exchange-traded fund designed to track a particular index. In the UK, some of the most popular indices include the FTSE 100 and FTSE 250, whereas, in the United States, the S&P 500 is often the go-to option. However, there are more focused fund options that track specific sectors or commodities that can cater to different investor risk tolerances.
- Real Estate – Investing in rental property can provide a steady monthly income stream. However, raising capital for this type of investment can be challenging and expensive. Not to mention, dealing with tenants can sometimes require more active involvement. Fortunately, there is a hands-off alternative. Investors can instead buy shares in a Real Estate Investment Trust (REIT), which invests shareholder capital into real estate and returns the rental income as dividends.
- Investment Adviser – For individuals with a higher net worth, hiring an investment adviser to manage an investment portfolio is an alternative hands-off approach to building wealth.
- Robo–Adviser – For individuals with a lower net worth, robo-advisers are becoming increasingly popular. These automated investing algorithms manage an investor’s assets based on their investment goals and risk tolerance.
Advantages of passive investing strategies
While passive investing is often a more boring method of building wealth, it does come with some significant advantages.
- Simple & Low Effort – The stock market is a complicated wealth-building mechanism that can quickly destroy wealth when mistakes are made. Learning how to pick stocks, analyse market trends, and forecast future returns requires in-depth knowledge that individuals may be unable or unwilling to spend time learning. And yet, these challenges can be almost entirely bypassed by using a passive strategy, letting both novice and experienced investors build wealth without having to provide much oversight or portfolio management.
- Low Cost – As previously mentioned, investing passively incurs fewer transactions, reducing the investment fees paid each year.
- Transparent – Most passive investing vehicles provide enormous transparency where capital is invested. Mutual funds disclose which types of securities they invest in, what sectors they’re exposed to, and how diversified their portfolios are. This makes it incredibly easy for investors to know exactly where their money is being allocated and how much risk they’re exposed to.
- Tax Efficient – Every country has different tax treatments for capital gains. However, positions that are held longer than 12 months are taxed more generously than investments held for shorter periods.
Disadvantages of passive investing strategies
As powerful as the advantages of passive investing can be, it’s not without drawbacks.
- Limited Choice – The stock market is home to thousands of publically traded companies. However, the vast majority are unsuitable for passive investing strategies. The same applies to most asset types that cannot be used in a passive portfolio. This limits the number of choices a passive investor has when deciding where to invest their money.
- Limited Returns – Since passive investors aren’t actively picking individual stocks, the maximum returns an investor can achieve are limited. For those investing in an index fund, generating the market-beating returns that picking individual stocks can provide is impossible.
- Limited Control – When investing through passive funds or trusts, investors have next to no control over where their money ends up being invested. For example, buying shares in a FTSE 100 exchange-traded fund is equivalent to indirectly investing in each of the UK’s top 100 companies. However, if there are some specific companies an investor doesn’t want to own, such as tobacco stocks, there is no way to exclude them.
Passive vs active investing strategies
The general approach of passive investing strategies is to mirror the stock market’s performance. By comparison, active investing strategies seek to outperform the stock market and achieve higher returns to accelerate the wealth-building process.
Active investors have far more control over their capital. But it comes at the cost of effort. Investors deploying active management strategies must perform all necessary research, risk analysis, and portfolio management. While investors can choose to buy shares in active mutual funds, historically, these investment vehicles have failed to deliver market-beating returns after deducting management fees.
Needless to say, active management is a far more time-consuming process. Services like The Money Cog Premium can significantly cut down the research time in the search for top-notch stocks. However, a passive strategy may be more suitable for investors unable or unwilling to spend time actively managing their investment portfolios.
RELATED: Active vs Passive investing: which approach is best?
Alternative Investing Strategies
The stock market is a giant sandbox. And there are far more alternative investment strategies that investors can adopt to build wealth. Investors should spend time researching and exploring each option to find the most suitable strategy for their personal circumstances.
- Active – Investors seek to outperform the stock market by picking individual stocks and capitalising on short-term trends.
- Momentum – Investors focus on stock price momentum rather than underlying fundamentals. Decisions are made solely based on price action and trading volume.
- Value – This investing strategy involves buying securities trading at prices below their estimated intrinsic value.
- Growth – This investment strategy involves investing in companies, industries, and sectors that are growing and are expected to grow significantly in the future.
- Small-Cap – Focuses on smaller businesses that aren’t as widely followed by financial institutions. This region of the stock market can often be riskier. However, it’s also where some terrific undervalued long-term growth opportunities can be discovered.
- Dividend – Investors focus solely on businesses that provide a stable dividend to shareholders to build a portfolio that generates a reliable stream of passive income.
- ESG – This strategy exclusively considers companies that score highly on environmental and societal responsibility scales as determined by independent firms and research groups.
- Factor – This investment strategy focuses on assets based on certain characteristics that have been proven to outperform over long time horizons.
Should I use a passive investing strategy?
Passive investing strategies are immensely popular due to their simplicity and hands-off management requirements. However, that doesn’t necessarily make it a suitable option for all investors.
Passive investing requires a monumental amount of patience and the ability not to panic during stock market crashes and corrections. The latter is often easier said than done. And naturally impatient individuals will likely struggle to build wealth using a passive investing strategy.
That’s why it’s important for investors to explore all the available options to decide which one is best for their personal circumstances.
The bottom line
Passive investing is beneficial for investors who have a long-term approach. It is low cost, low effort, and provides an easy solution to replicating the stock market’s average returns. However, it also has some drawbacks. Total gains can be limited, and investors often have limited choices and control over their investment portfolios.
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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.