Investing > Complete Guide to Passive Investing

Complete Guide to Passive Investing

There’s more to investing than quick turnovers. Sometimes, it pays to hold.

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Updated June 10, 2022

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They say money doesn’t grow on trees, but what if it did?

Imagine if you could head to the store, buy some seeds, and plant them knowing that in a few years, give or take, you’d have access to funds right from your backyard. One can dream, right? 😴

Well, we might not have magical money trees, but we do have investment strategies that can help us grow a decent amount of funds to help meet our long-term goals. Cue, passive investing.

Championed as the ideal approach to building a “lazy portfolio”, passive investing allows investors to participate in the stock market with relatively minimal risk – and stress. When people hear “passive” they immediately think: retirement.

And while this investment strategy is the go-to approach for building wealth for the future, investors can incorporate it into meeting other future plans. In fact, passive investments don’t just have to be for long-term plans, alone.

More investors are incorporating passive investing into their strategies, shifting away from active management in search of lower costs, risk, and headaches. Alternatively, if active trading is your thing, you can simply add passive investing as a means to manage risk and secure some certainty for the future.

But, that’s a conversation we’ll have later on. For now, sit back and relax as we take you through the basics of passive investing, highlighting its most common forms, and also weighing it up against its active rival.

Shall we begin? 👇

What you’ll learn
  • What is Passive Investing?
  • Passive Investing Strategies
  • Advantages of Passive Investing
  • Disadvantages of Passive Investing
  • Passive Investing And Crypto
  • Passive and Active Investing - Combined
  • Is Passive Investing Right For You?
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

What is Passive Investing? 📚

Also known as the “buy and hold strategy,” passive investing is a long-term investment strategy that involves buying securities that mirror stock market indexes and holding them long term. 

Passive investments are the “fine wine” of investing. The longer you hold onto them, the more time they have to mature and bring in delicious returns. Or, decent ones at the very least. 

Passive investing is for the long haul, which might not be ideal for investors who want a quick turnover. But for those who don’t have time to track their trades on a daily basis – and prefer to keep their blood pressure low – this is a great investment strategy for growing wealth at a gradual pace.

Plus, considering the rocky performance of active investing in the last year, perhaps there is much to be learned from passive investors and their “lazy” approach. You know how the saying goes: if you can’t beat the market, match it – or something like that.

Passive Investing Strategies 📜

Trees, even money trees, require an intentional approach in order for them to grow to their fullest potential – the same goes for passive investing. In order for investors to get the best out of this strategy, they need to approach it with a clearly thought-out plan. 

What’s a plan without strategy? In this section, we cover the different passive strategies investors can use to grow their portfolio.

Index Fund 📈

An index fund is a type of mutual fund that seeks to track the returns of a market index, such as the S&P 500 and the Russell 2000 Index. 

We can’t talk about passive investing without mentioning index funds. Index investing is a relatively low-risk strategy that can grow a portfolio over the course of 20 to 30 years.

Index funds can be based on practically any financial market, like equities, fixed income, and commodities, consisting of several asset classes such as stocks and bonds. They also have lower costs and require less maintenance than other investment vehicles. ⏳

Besides that, the most significant pull for index funds is automatic portfolio diversification. Index funds investors are exposed to all the shares of the companies that the fund tracks. This reduces the correlation between stocks and spreads the risk of investment across all assets.

Think of it this way: Sarah decides to invest in 100 companies at random. What are the chances of her losing every single investment? Almost little to none.

While she might not get the best results from investing without a strategy, Sarah is still in a better position to gain because the risk is spread across all her assets and is unlikely to be affected by a shared adverse event.

Additionally, index funds offer excellent diversification since one is essentially investing in a fair share of companies in representative benchmarks like S&P 500 or the Vanguard 500 Index Fund.

A drawback worth mentioning, however, is the fact that trades can only be sold after the market closes. Not ideal for investors looking for a strategy that offers more flexibility. Enter, ETFs.

Exchange-Traded Funds 💰

Exchange-traded funds, also known as ETFs, are professionally-managed, diversified portfolios of investments that can be traded like stocks. 

A firm favorite among investors, ETFs hold a few advantages over index funds. The main one being trading flexibility. As we mentioned earlier, index funds can only be traded once a day, when the markets have closed.

This means that investors have to wait until the close of the trading day to find out the price they paid for new assets when buying that day. The same goes for learning about the price they will receive for shares sold during that particular day. Making changes to index funds requires more time – days, to be precise. For most passive investors, that’s fine but some investors prefer more flexibility.

ETFs, however, are bought and sold throughout the course of the day, so investors will know, within a short period of time, the price they paid to buy shares and the amount received after selling. This almost immediate trading of ETF shares makes it easier to manage a portfolio on a day-to-day basis, compared to index funds. ☀

Additionally, investors have room to move funds between specific assets, including stocks, bonds, and other asset classes. So, if Mark wants to redirect funds to different investments within the hour, he can get this done within that time frame. While this practice isn’t recommended, it is possible to execute.

Along with flexibility, ETFs also offer lower operating costs compared to index funds. Although the fee structure can be confusing, ETFs tend to have a lower yearly cost as well as less fees than their index counterparts. And, if an investor registers with a reputable app to trade stocks, they will often find that they can trade their ETFs completely fee-free.

Another significant advantage ETFs have over all other asset types is that capital gain taxes only apply when the holdings are sold. This is great with passive investing since you won’t sell your holdings frequently anyway.

Robo Advisors 🤖

Some investors prefer a full-on hands-off approach to their investing—this is where robo-advisors come in.

Robo-advisors are digital platforms that automatically build an investor’s portfolio with little to no human supervision.  

This automated service uses computer algorithms to manage quick assets, price checks, and quotes on time scales that are much narrower and more accurate than humans could manage. 

Typically, an investor starts by answering a questionnaire about their financial situation and investment goals. The robo-advisor then uses this data to build a portfolio that best aligns with one’s investment goals and automatically invests funds for them. 

Many robo-advisors on the market focus on diversifying an investor’s portfolio to get better returns while keeping their investments safe. 🛡

Not only that, but they completely remove emotions from the equation, which comes in handy for investors who tend to get scared or nervous when market conditions are poor. Without the need for human advisors, the most popular robo-advisors typically have lower fees or even no fees at all.

That said, a robo advisor can’t replace the human element in investing. They are best suited to simpler goals and they do not offer financial planning advice. When an investor knows their needs, it’s easier for them to decide on strictly using a robo-advisor, mixing the best of a robo and traditional advisor, or sticking to a traditional financial advisor for guidance.

Table highlighting the difference between robo-advisors, traditional advisors, and a hybrid approach.
Based on their needs, investors can choose three types of advisors: robo, robo + traditional, or traditional advisors.

Advantages of Passive Investing 🌟

A big draw to passive investing is simplicity and convenience. By owning an index fund or ETF, investors don’t have to create a dynamic strategy that requires constant research and adjustment. They can continue with their day-to-day tasks while their investments grow over time.

There’s no need to predict winners, losers, or time entry points since investors will most likely come up on top at the end of the road anyway. When a 20-year period is considered, passive funds almost consistently outperform active ones. 

In fact, according to Forbes, nearly 90% of index tracking companies outperform their active counterparts while offering lower risk and volatility. 

Considering capital gains taxes are paid every time holdings are sold, passive investors have a significant advantage as they naturally have fewer transactions. Not only is the amount of taxes you pay lower, but you’d also not have to pay it as often, making it much easier to navigate tax season.

Besides that, passive investing offers automatic portfolio diversification as investors technically own shares of multiple companies by simply buying index funds or ETFs. Because the risk is spread out, they’re highly unlikely to incur major losses during adverse industry-specific events or recessions, providing more security and safety when it comes to their investments.  

Disadvantages of Passive Investing 🚧

While it’s considered “safer and easier” to buy these index funds or ETFs, they are limited to a specific index or predetermined set of investments, which locks investors in with very little flexibility. 

No matter what happens in the market, investors won’t be able to cut an underperforming stock within the index because they don’t own the underlying stocks directly. 

Many investors also shy away from passive investing because it takes far longer to see significant returns. While passive funds hedge against poor market conditions and recessions, in theory, they rarely beat the market within ten years. 

Passive funds do pay off in time, but they’ll never give one the kind of massive windfalls that one sees in movies. 💸

Investors must remember that they always run a risk of losing all their capital in the stock market despite how safe passive investing usually is. While tech stock prices are still currently high, co-founder of analytics firm DataSwarm, Alan Patrick speculates that we may be at the foothill of a tech bubble.

Following the Dot-Com bubble burst in March 2000, the S&P 500 took nearly seven years to recover. This brings to question what a huge stock market crash could do to long-term investors. Given the time involved in holding and nurturing the assets, passive investors would have effectively lost decades of their life without gaining any benefit for it.

Passive Investing And Crypto 🪙

Many investors have started looking into crypto investing for wealth building and passive income since the 2018 crypto market collapse and subsequent resurrection. It has become a popular and viable tool for accumulating wealth, but given the volatile nature of cryptocurrency, there are a few factors you should consider before diving into crypto investment.

Compared to stable, safe assets like index funds or ETFs, Bitcoin has the most significant risk-adjusted returns – based on the Sharpe ratio. Since only 2.1 million Bitcoins can circulate the market at any given time, Bitcoin is highly desirable to investors as it is verifiable and has built-in scarcity.

Considering a high-yield crypto savings account can earn clients up to 6% interest, storing cash as crypto is, debatably, more accessible and potentially more lucrative.

However, there’s no telling what crypto returns would be like in the future since they have only recently become more popular. There has also been a rise in crypto scams, where investors lost all their money after malicious crypto developers abandoned the project. 👨‍💻

Since crypto uses blockchain technology independent of public banks and governments, there’s always a possibility of losing all your investments without an avenue to recover your funds.

Before investing in crypto, investors should make sure that all their bases are covered. For starters, an investor should not invest or store more than 5% of their portfolio as crypto. 

Not only that, but investors should make sure that they have a dependable emergency fund, a retirement fund in the form of a Roth IRA or 401(k), and a passive fund consisting of stable assets like index funds or ETFs. 

Combining Passive and Active Investing 🔗

Investing isn’t a one-size-fits-all practice and that’s a good thing. Our preferred approaches might not be the same as the next investor’s and there’s nothing wrong with that. The goal for all investors should be to identify a set of strategies to best help them reach their individual goals.

“Slow and steady” isn’t for everyone and this is where active investing comes in. The limitations that come with passive strategies, like not being able to handpick individual stocks, might prove frustrating to investors with specific interests.

So, the conversation here shouldn’t be about choosing between active and passive investing; because investors can create a strategy that incorporates both. In fact, many veteran investors actively endorse such a hybrid approach. According to the Modern Portfolio Theory, diversification is a critical component of successful investing. 🎯

Investors can also learn how to actively manage their investments if they don’t mind venturing into relatively new assets and losing some capital. Many conservative investors have an 80/20 asset allocation, with 80% in safer assets like index funds or bonds and 20% in stocks. 

Theoretically, this provides the best of both worlds— one can take advantage of short-term upwards movements while safer assets continue to grow in the background. Take Michael, for example.

He’s just hit 30 and wants to take advantage of the time he has to build a healthy passive fund in the next 20 to 30 years. He plans on putting a considerable amount of money into low risk stocks, and will check on his investments periodically. 📝

But, Michael’s also read up on penny stocks and wants to reap the benefits from these highly volatile assets as well. He’s good with risk, so their volatility doesn’t move him much. But, he also feels comfortable enough to delve into riskier options because of the long-term fund he’s set up.

The risk of investing will also be spread across all assets, making it highly unlikely to lose all capital from one bad trade. 

Ultimately, how investors manage their assets depends on what they have on hand and their risk tolerance. Suppose you’re just starting out and don’t mind losing some money to learn valuable trading lessons. 

In that case, you can go harder on active portfolio management while leaving some assets to grow over time as a safety net. At the end of the day, it’s about finding what works best for you.

Is Passive Investing Right For You? 🤔

It’s easy to see why passive investing is on the rise. After the market’s volatile performance in the last 2 years, investors are trading high-risk strategies for sure, steady growth. While passive investments do get affected by the dips in the market, these tend to smooth out and rise in the long run. 

Additionally, passive investing is a far better approach for retirement planning, or simply just  growing one’s income for future use. Sometimes, it does pay to wait.

That said, this strategy isn’t without its limitations as we’ve already spoken about before. Not everyone sees the joy in waiting, and even though this strategy is much safer than active investing – anything can happen in the market.

Whether this strategy will work for your goals or not, is solely up to you. Consider your plans for both the short and long-term, and see if passive investing can help you reach your destination.

Investors also need to consider their tolerance for risk, as this will play a major part in identifying their ideal investment strategy. A hybrid strategy is great for anyone who’s looking to raise their tolerance, while passively building their fund on the side.

Conclusion 🏁

Passive investing is a beneficial long-term portfolio management strategy that works for investors of all experience levels. Since it averages out the peaks and dips of the market, inventors can secure their assets and hedge against recessions without much active participation. 

All in all, it pays to hold assets for decades in multiple ways. 

That said, an entirely passive portfolio might not give you the type of life-changing returns, which is why most investors allocate a portion of their capital to high-risk/high-reward assets like IPOs or real estate.

At the end of the day, passive investing is most suitable for investors who have a lower risk tolerance and prioritize protecting their assets.

Passive Investing: FAQs

  • When Did Passive Investing Get Popular?

    Passive investing started gaining popularity around 1976 when John "Jack" Bogle, the founder of Vanguard, created the world's first retail index fund. Since then, it has inspired the creation of several index funds, as well as ETFs, that offer significant returns for long-term holdings. 

  • Is Passive Investing Safe?

    Yes, passive investing is one of the safest investment strategies since it operates on the premise that risk gets spread out across individual investments within the index fund or ETF. It's a good portfolio management strategy that works best for conservative investors who don't mind leaving their assets to grow over decades. 

  • Is Passive or Active Investing Better?

    Passive investing or a hybrid of passive and active portfolio management are all viable strategies for wealth accumulation or simply as a starting point for investing. But if the goal is to pull as much money from the stock market as possible, active investing might be a better strategy. There's no determining whether passive or active investing is better without first looking into trading style, financial goals, cash flow, and risk tolerance—the choice is entirely up to the investor’s preference.

  • Who Manages Passive Investing?

    Most index funds are managed by one of three passive asset managers: Black Rock, Vanguard, and State Street. However, there is no need to choose individual managers since index funds track the entire market. When the overall stock market prices fall, so do index funds. 

  • Is Passive Income Taxable?

    Yes, passive income is taxable according to the investor’s active income tax rate. However, the liability can sometimes be reduced through tax deductions. Dividends and income derived from investments are classified as portfolio income, which is taxed depending on how long the fund was held. If the fund was held for over 60 days before the dividends were issued, dividends could be taxed anywhere from 0% to 20%, depending on the investor’s individual tax rate.

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