The benefits of passive investing (2024)

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Jul 19, 2022

By Team Stash

Passive investing is a strategy meant to build wealth gradually by buying securities and holding them long-term. Also known as a buy-and-hold strategy, passive investing methods seek to avoid the fees and risk often associated with frequent trading. It assumes that the market posts positive returns over time, so it’s better to put time into the market instead of trying to time the market. Index funds, which can include mutual funds and exchange-traded funds (ETFs), are designed to mimic the performance of market indexes, making them the primary player in a passive investment strategy.

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In this article, we’ll cover:

  • How passive investing started
  • Active investing vs passive investing
  • Building your passive investing strategy
  • Benefits of passive investing
  • Downsides of passive investing

The invention of the passive investing concept

Jack Bogle, the founder of The Vanguard Group, pioneered the index fund in 1975. Also known as a passive fund, index funds were a revolutionary addition to the market because they allowed retail investors with a brokerage account to compete with professionals. When index funds were first introduced, mutual funds were the main vehicle for passive investing. Since then, ETFs have become the most common type of passive fund. Today, around 71% of investors agree that passive investing is generally superior to active investing for maximizing long-term market returns.

Active vs. passive investing

As the names imply, active investing requires a more hands-on approach, while passive investing requires less frequent buying and selling of stocks and other securities (not to be confused with passive income).

Active investing is done with the goal of “beating” or “timing” the stock market, usually with a very hands-on portfolio manager. It tends to be riskier, as investors must guess how stock prices may change day-to-day, or even within a single day. This type of investing can also be more expensive as active investors pay more fees associated with making trades. It’s geared toward more aggressive investors who aim to take advantage of short-term price fluctuations in the market.

On the other hand, passive investing is a long-term game. It can be a more cost-effective way to invest because fewer trades mean fewer fees. Passive investors build a diversified portfolio, often with the support of a robo advisor, then adopt a “buy and hold” mentality, resisting the urge to predict or react to market fluctuations. Successful passive investing rides out short-term setbacks in favor of focusing on long-term returns and overall portfolio performance, which may reduce the risk associated with market volatility.

Active investing (hands-on)Passive investing (hands-off)
High volume of tradesBuy-and-hold approach
Hands-on portfolio managementLess frequent portfolio management
Tends to focus on individual securitiesTends to focus on a diversified portfolio
Higher riskLower risk
Geared toward short-term returnsGeared toward long-term returns

Passive investing strategies

While many different types of investments may support a passive strategy, passively managed mutual funds and ETFs are common choices because they have a degree of diversification built in. Index funds are especially suited to passive investing because they aim to mimic the way indexes like the S&P 500 behave; these indexes often reflect steady growth over time. ETFs are unique in that they can be bought and sold on a stock exchange the same way that a regular stock can.

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Pros of passive investing

Passive investing relies on a diversified portfolio that’s built to see slow but steady gains over time. This approach is usually a simple, lower-risk, less expensive way to invest, especially for beginning investors. Additionally, the buy-and-hold strategy typically doesn’t result in a massive yearly capital gains tax. Pros of passive investing include:

  • Low maintenance
  • Tax-efficient
  • Diversified investments
  • Lower fees
  • Less risk
  • Steadier returns

Cons of passive investing

Investors hunting for large, short-term gains may find passive investing too limited. The strategy excludes opportunities to jump on a stock whose price may rise quickly, then sell before it falls; this active investing approach can be risky, but may provide a market return that exceeds overall market performance. If you have an aggressive risk profile, you might see some cons to passive investing, including:

  • Limited investment options
  • Fewer short-term gains
  • No above-market returns

Assessing your risk tolerance and profile

Knowing your tolerance for risk is key to determining the right investment strategy for you. Any type of investing has risks, of course, including the risk that you could lose money. But you can determine what you’re comfortable with by determining your risk profile. Depending on your age, income, time horizon, and financial goals, you’ll likely fall into one of these categories:

  • Conservative: You might be focused on stability, even if it means smaller gains.
  • Moderate: You’re probably looking for long-term growth potential, but you still want some amount of stability.
  • Aggressive: You may want to maximize your gains in the long run, even if it means sacrificing stability in the short term.

Discovering your investing approach

While investing strategies are flexible, it’s best to understand the overall investing approach that may work best for you before diving in. It could be passive management of your investments, active management, or a combination of both. It all depends on how much hands-on involvement you want and how much risk you’re willing to take with your investments. The good news is that if you choose one approach and it doesn’t work for your risk tolerance or time horizon, you can switch it up.

Passive investing is often focused on building wealth for the future, such as in retirement. These calculators can help you identify your long-term growth goals and how to get there:

  • How much money you need to retire
  • How much your investments could grow through compounding

Combined with your risk profile, those numbers can give you an idea of how much to invest and what strategy makes the most sense for you.

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The benefits of passive investing (2024)

FAQs

The benefits of passive investing? ›

Advantages of passive investing

What are the advantages of passive investing? ›

Passive investing is often less expensive than active investing because fund managers are not picking stocks or bonds. Passive funds allow a particular index to guide which securities are traded, which means there is not the added expense of research analysts. Even passively managed funds will charge fees.

What is the purpose of passive investing? ›

Passive investing is a less-involved investing strategy and focused more on the long-term. Passive investors aren't trading in an attempt to profit off of short-term market fluctuations. Instead, they add money to their portfolios at regular intervals, whether the market is up or down.

What are the benefits of active investing? ›

Flexibility. Active managers can buy stocks that may be undervalued and underappreciated in the general market. They can quickly divest themselves of underperforming stocks when the risks become too high. They can choose not to invest during certain periods and wait for good opportunities to buy.

Why are passive funds good? ›

Passive funds place investors' money in large samples of the market (for example the S&P 500 index) so that they reflect the average performance of the overall economy. Because they don't hunt for the potentially best performing stocks, their management fees are lower.

What is the goal of 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.

Why is passive investing becoming more popular? ›

Because active investing is generally more expensive (you need to pay research analysts and portfolio managers, as well as additional costs due to more frequent trading), many active managers fail to beat the index after accounting for expenses—consequently, passive investing has often outperformed active because of ...

Are passive funds safe? ›

While no investment can guarantee absolute safety, passive investments are generally considered more secure compared to actively managed ones. By mirroring a benchmark index, passive funds diversify investments, enhancing stability and risk distribution.

Is passive investing less risky? ›

Advantages of passive investing

Consistent and low-risk returns — Because of the extreme diversification in most passively traded funds, investors will usually see a consistent return on their investment with generally lower-risk active management.

Is 401k passive investing? ›

You may already be making passive investments through an employer-sponsored retirement plan such as a 401(k). If you're not, it's one of the easiest ways to get started and enjoy the benefits of passive investing.

Is investing the best passive income? ›

Investing can be a great way to generate passive income, but only if the assets you own pay dividends or interest. Non-dividend-paying stocks or assets like cryptocurrencies may be exciting, but they won't earn you passive income.

Does passive investing outperform the market? ›

Passive investing tends to perform better

Despite the fact that they put a lot of effort into it, the vast majority of of active fund managers underperform the market benchmark they're trying to beat. Even when actively managed funds do experience a period of outperformance, it doesn't tend to last long.

What are the benefits of active and passive income? ›

3) Level of risk

Active Income can be generally perceived as more stable and predictable, especially with regular employment. Passive Income can involve higher initial risk, especially in investments like real estate or stocks, but offers potentially higher long-term returns.

Who manages passive investing? ›

The bulk of money in Passive index funds are invested with the three passive asset managers: BlackRock, Vanguard and State Street.

How does passive income benefit you? ›

And, when you have passive investments, you have more money at your disposal. That means that you've got more spare cash to put aside into savings to help you save for big purchases such as car, house, or tuition payment. In other words, your passive income helps you meet your goals faster!

What are the tax benefits of a passive investor? ›

Passive investors can take advantage of tax loss harvesting, a strategy to offset capital gains with capital losses. This can be done by selling lost value investments and using the losses to offset gains from other investments. This can help to reduce your overall tax bill and increase your after-tax returns.

What are the advantages of indirect investment? ›

In many ways, indirect investment is not as risky, even though you are still advised to exercise caution. Other advantages include improved asset liquidity. For example, there is an active market for stocks and shares making it significantly easier to sell them quickly and cost-effectively.

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