What is passive investing and is it worth it?

| Last Updated September 1, 2022

Investor using a passive investing strategy to grow wealth

Key Points

  • The first passive fund was created by Vanguard 500 to track the S&P 500 in 1970.
  • Passive funds try to duplicate the performance of a major index.
  • Passive investing has low risk and low returns.

The buy & hold investment strategy has been around for decades and remains popular today. It’s based on the introduction of the passive investing style popularised by John Bole in 1970, following the creation of an S&P 500 index tracker by Vanguard.

Today there are over 496 mutual funds using a passive investing style in the United States alone. That obviously provides a lot of choice to investors. But exactly is passive investing? How does it work, and is it even worth it?

What is passive investing?

Passive investing revolves around buying and holding assets for a long period, usually five years or more. The objective is to achieve a steady and consistent return to grow wealth over time. This differs from the active investing style, which seeks to generate higher returns faster at the cost of added risk.

Beating the stock market using a passive investing strategy is rare. Most investors are keen to leave their investments on autopilot and often settle for buying shares in an index fund or exchange traded fund (ETF).

This is an easy and proven method to replicate an index’s performance. The level of return ultimately depends on which index to track. Here in the UK, the FTSE 100 has historically offered a return of around 8% annual, including dividends. By comparison, the S&P 500 in the US is closer to 10%.

Does active management outperform passive management?

The goal of the passive manager is to replicate the financial index performance rather than taking on risks to try and beat it. So naturally, most would assume that active managers generate higher returns than a passive portfolio.

In reality, the situation is a bit more complicated. There are several actively managed investment funds that outperform passive funds by a wide margin. But there are also significantly more that fail even to generate a positive return. The numbers get even worse when management fees are taken into account, which tends to be much higher for an actively managed fund.

Morningstar recently analysed the performance of 3,000 active funds between June 2020 and 2021. Only 47% survived the turmoil and beat their passive fund counterparts.

In other words, while active investing opens the door to higher returns, it requires investors to be able to identify market-beating investment opportunities. And that’s something even professionals are struggling with.

RELATED: Active vs Passive Investing: Which one is better?

What are the pros and cons of passive investing?

Despite these glaring figures, passive investing is far from perfect.In fact, a passive investor does have quite a few disadvantages over an active investor.

AdvantagesDisadvantages
The absence of anxiety that comes with active investing.The returns are lower compared to active investing.
Low cost is involved in making a passive investment.A passive investment lacks flexibility. Unlike active investing, this one does not involve quick decisions and fast transactions. Hence, it can negatively impact the investment.
There are lower risks as risks are evenly spread.Passive investors don’t gain the performance advantages of natural portfolio concentration.
The one-time investment gives the investor wide diversification if using index investing.

Should I add a passive fund to my portfolio, and is it even worth it?

Since the ingestion of index trackers, becoming a passive investor has become exceptionally easy. And that includes those with little to no knowledge about how the stock market works.

Buying shares of a passive fund creates an instantly diversified portfolio in a single transaction keeping commission costs low. And since portfolio management and asset allocation are handled by a fund manager, there is little effort required to keep everything in check.

This is why legendary investor Warren Buffett favours index tracker funds over active investing. And it’s a strategy that I’m personally fond of and think is worthwhile. However, personally, I like to blend passive with active to enjoy the best of both worlds.

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Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.