What Is passive investing?

By: Team Stash • Reviewed by: Heather Comella

Published: Apr 19, 2024 • Updated: Aug 27, 2024

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.

In this article:

1. Active vs. passive investing
2. Pros and cons of passive investing
3. Passive investing strategies
4. Discovering your investing approach
5. Is passive investing right for you?

Passive investing has gained popularity in recent years, with passively-managed index funds constituting 45% of total assets managed by U.S. investment companies in 2022. That trend shows no sign of slowing, with passive assets in funds expected to surpass active assets in 2024. Is a passive investment strategy right for you? Read on to learn how this approach works and whether it might be a good fit for your investing goals.

Active vs. passive investing

Active investing is a hands-on approach where the primary goal is to outperform the market. This method involves frequent trading and a strategic focus on timing the market to achieve superior returns. While active investing can offer the potential for higher returns, it also comes with increased risk; investors must constantly monitor the market and try to guess how it will move in the short term. Because the stock market is notoriously volatile, it’s difficult for even seasoned experts to predict how stock prices will fluctuate in the short term. For everyday investors, active investing also poses the challenge of having to devote significant time and effort to portfolio management or pay higher fees to invest in an actively managed mutual fund or exchange-traded fund (ETF).

On the other hand, passive investing emphasizes simplicity and long-term growth, aiming to mirror market performance rather than beat it. Investors take a buy-and-hold approach instead of frequently trading, building a diversified portfolio of investments and hanging onto assets for many years to ride out short-term volatility. This approach tends to result in lower fees, reduced risk, and steadier, more predictable returns over time. For beginners just learning how to invest in stocks or people without the time and expertise to intensely monitor and interpret market conditions, passive strategies might offer a straightforward way to invest in the stock market. Additionally, robo-advisors can help those looking for a hands-off approach by automating their investment strategy based on risk tolerance and goals.

Pros and cons of passive investing

Passive investing has a wide range of benefits, but it also comes with potential drawbacks. While it can certainly be profitable, this strategy generally prioritizes stability and simplicity over high returns.

Pros of passive investing

With a low-maintenance and cost-effective approach to managing your investments, a passive investing method can help you maintain a diversified portfolio to lower risk, plus reduce both the stress and fees associated with investing.

• Low maintenance: Passive investing requires less time and effort, as it involves fewer transactions.
• Tax efficient: This strategy often results in lower capital gains taxes due to fewer trades.
• Diversified investments: Passive portfolios typically hold a broad range of assets, which can reduce the risk of substantial losses due to downturns in any one stock or sector.
• Low fees: With minimal trading, passive investing can incur lower management and transaction fees.
• Less risk: By aiming to mirror the market, passive investing is often considered safer than attempting to outperform the market.
• Steadier returns: Over time, passive investing tends to offer more consistent returns compared to active strategies.

Cons of passive investing

Passive investing also comes with constraints, such as limited investment options and the inability to achieve above-market returns, which may not align with the goals of more active or growth-focused investors.

• Limited investment options: Passive strategies often focus on investing in index funds and ETFs, which may limit exposure to specialized or emerging market sectors.
• Less chance of above-market returns: Passive strategies aim to match, not exceed, market performance, potentially missing out on higher returns during market upswings.
• Less responsive to market fluctuations: This approach is not designed for capitalizing on short-term market trends, which might be a drawback for those looking to take advantage of immediate market movements.
• Potential for complacency: With a set-and-forget-it mindset, there’s a risk of becoming less engaged with your investments, which could lead to missed opportunities for portfolio adjustments based on changing financial goals or market conditions.

Passive investing strategies

To build a passive investing strategy, you’ll need a keen understanding of the different types of investments and how they function. Many passive investors rely primarily on funds, but there can be room for stocks and bonds in this strategy as well.

Passive investing and funds

Funds are one of the most common passive investing vehicles because they come with built-in diversification, and many are built specifically to mirror the performance of the stock market.

• Index funds are designed to match the performance of a specific stock index, like the S&P 500. They’re often a popular choice for passive investors because they offer broad market exposure with minimal effort. One risk with index funds is tracking error, which is when the fund’s attempt to match its benchmark index misses the mark.
• An ETF is a basket of securities that may include a variety of asset classes. They’re traded on a stock exchange, just like individual stocks. When you buy shares of the fund, you’re investing in the entire collection of securities it holds. Most ETFs are passively managed, and there are many options for ETFs that track a specific market index.
• A mutual fund is similar to an ETF: a collection of securities within a single fund. Mutual funds are more likely to be actively managed, but there are several passively managed options that can align with a passive investing strategy. Mutual funds tend to be less liquid than ETFs because they can only be sold at the end of the trading day, and some funds have rules that limit your ability to sell your shares immediately.

The role of stocks and bonds in passive investing

Because passive investing is rooted in slow and steady returns over the long haul, it may seem incongruent with the volatility of the stock market, but certain kinds of stocks may have a place in a passively managed portfolio. Bonds may also be appealing to passive investors due to their lower risk and fixed terms.

• Dividend stocks: Dividends are a portion of a company’s profits that are paid to shareholders on a regular basis. Not all stocks pay dividends, but those that do can provide steady passive income, which can be automatically reinvested to take advantage of compound returns. In a passive investing strategy, investors are likely to look for dividend-paying stocks from companies that have a long history of stable returns, such as blue-chip stocks.
• Bonds: Bonds generally offer steady, fixed income over a set period of time. They’re essentially a loan that an investor makes to the government or a company, which is paid back with interest. As long as you hold the bond to maturity, there’s no active management required. While returns can be lower than both stocks and funds, bonds generally come with much lower risk, so they can align with a passive investing strategy.

Discovering your investing approach

Finding your personal investment style can help you decide if a passive investing strategy is right for you. You’ll want to consider your risk tolerance, financial goals, and overall comfort with investing.

Assessing your risk tolerance and profile

All investing comes with risk; how much you’re able to tolerate has a profound impact on your investing strategy. Your risk profile describes the level of uncertainty you’re comfortable with, and it’s defined by factors such as your age, income, and time horizon for reaching your investing goals.

Risk tolerance is generally grouped into three categories:

• Conservative: Ideal for those who prioritize stability and preservation of capital over higher returns. This approach is often suitable for people nearing retirement or those who prefer minimal risk.
• Moderate: A balanced approach for those who seek a middle ground between risk and return. This profile fits investors who are comfortable with some market fluctuations but still prefer a level of stability.
• Aggressive: Some people are willing to accept higher levels of risk in the short term for the potential of greater returns. This style is often chosen by younger investors with a longer investment horizon, as they have more time to recover from short-term losses.

Conservative and moderate investors are often comfortable with a passive strategy that prioritizes stability, while aggressive investors may want to take a more active approach.

Determining your financial goals and timeline

When it comes to investing, it often pays to think far into the future. Your financial goals, especially how long you have to achieve them, affect your investing approach. Because passive investing is focused on growing your money over the long term, the strategy tends to align well with objectives like saving for retirement or a child’s college education. The longer you keep your money invested, the more time it has to grow.

You might want to do some calculations to get a sense of how passive investing might align with your long-term goals.

• Retirement: Use a retirement calculator to determine how much money you’ll need to retire and how long it will take you to hit that goal.
• Compounding: Try a compounding calculator to estimate how much your money might grow over time.

Combined with your risk profile, your financial goals and timeline for achieving them can help you decide if passive investing aligns with what you hope to achieve.

Consider your comfort level with investing

Does the idea of frequently monitoring your portfolio and making trades fill you with excitement or anxiety? Do you feel confident in your knowledge of how financial markets work? How much time can you devote to managing your investments?

Regardless of your investment approach, it’s wise to keep up to date with market developments and periodically check in on your portfolio. But passive investing allows you to devote much less time and mental energy to the process. That’s one reason this strategy often feels more accessible to beginner investors and busy people who don’t have room on their plate to constantly manage their investments.

Is passive investing right for you?

Passive investing offers a straightforward, lower-risk approach to growing your wealth over time. So how do you decide if you should take a passive or active approach? The good news is, you don’t have to stick to just one strategy. Many investors adopt a buy-and-hold approach for most of their investments, while making more active choices about specific aspects of their portfolio. In addition, beginner investors might feel more comfortable opening a brokerage account and getting started with a passive approach, then taking a more active role as they learn more about the ins and outs of investing.

Whatever path you take, the sooner you start investing, the more opportunities you have to build your wealth over time. The Stash Way focuses on regularly investing in a diversified portfolio for the long term, which can support your passive investing strategy as well as empower you to actively manage your investments.