What Is Passive Investing and How Does It Work?

Kelly Hernandez
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Passive investing is considered a long-term solution to financial troubles because it uses the typical yet slow profit increase that is usually seen in the market over several years. Passive investors place their money into long-term investment vehicles, including the stock market, then wait for their investments to grow before pulling them out, along with their profit. These investors rarely move their money around to different investment vehicles once they make their initial investments.

This investment strategy may sometimes be referred to as a “set it and forget it” mentality because it requires you to buy investments and hold them. Frequent transactions or exchanges of money are not involved in a passive investment strategy, so it’s much different than active investment management. While active investments are expected to create profit quickly, passive investments take longer to grow and are commonly used for retirement funds.

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How Does Passive Investing Work?

Passive investors do substantial research on which stocks they should invest in. While these investors don’t participate in many transactions, there is a lot of behind-the-scenes work that goes into passive investing. This extensive research allows investors to choose the stocks they believe will make them the most money in the long term.

Once investors have identified the stocks they believe will grow over time, they invest their money into these stocks and don’t move it for years. Passive investors aren’t attempting to “outsmart” the market or make money on their investments everyday, they’re simply waiting for gradual increases in the value of the stocks they’ve invested in over time.

Pros of Passive Investing

If you have the patience and time to wait for your investments to grow, you may experience some of the benefits of passive investing, including:

  • Low fees: With a passive investing strategy, you’re not consistently buying and selling stocks or relying on an expert’s opinion on short-term fluctuations, so you can avoid paying the expensive fees associated with stock market trading.
  • Transparency: If you’re using an index fund, it’s always clear where your money and assets are invested.
  • Tax-efficiency: Since you usually won’t show a high profit in the first year or two of investing, your taxable capital gains will remain low, along with your tax liability.
  • Stability: While your investments may still fluctuate daily in the market, your overall investment strategy is more stable than an active investment strategy because it involves long-term growth.
  • Simplicity: The constant adjustments you must make with an active investment strategy can be confusing and complicated, whereas passive investing offers a more simplistic approach that doesn’t involve consistent monitoring.

Cons of Passive Investing

Passive investing isn’t for everyone and there are drawbacks to this investment strategy, including:

  • Limited funds: With passive funds, you’re limited to a specific index, or set of investments, no matter what happens in the market.
  • No short-term gains: You must be able to wait for long-term investments to pay off, since you may not experience any short-term gains with passive investing.
  • Potentially smaller returns: In the end, there aren’t any guarantees on investment returns, so your profit may be small, even with a long-term passive investment strategy.

Passive Investing Strategies

While all passive investment strategies focus on long-term profits, there are different ways you can invest your money. If you’re just beginning to dabble in long-term investing, one or a combination of these passive investment strategies could be beneficial for your financial gain.

Index Funds

An index fund is the most common passive investment strategy because it’s basically a portfolio of stocks on the market. Rather than picking out individual stocks to invest in, the investor buys all the stocks grouped together for one price. This allows investors to diversify their passive investments without extensive research on each stock available.

Exchange-Traded Funds

Exchange-traded funds are a collection of securities and can contain many different passive investment vehicles, including commodities, stocks, or bonds. These funds follow a specific index fund, such as the S&P 500, MSCI Indexes, or Dow Jones Industrial Average, so they can track the market. With exchange-traded funds, you can trade index funds on an exchange, similar to stocks.

Mutual Funds

As a passive investor, mutual funds allow you to benefit from both professional management and diversification. When you buy mutual funds, you’re buying funds through a company that will buy and sell stocks, bonds, and other investment vehicles in your name. The company manages this portfolio for you and makes investment moves on your behalf.

Active vs Passive Investing

If the potential long-term profits you can earn from passive investments doesn’t appeal to you, active investing may be the strategy you want to use to grow your money now.

With active investing, you use short-term strategies to increase your income. However, to be profitable with this strategy, you must watch your investments closely, as well as the market, and react quickly to its behavior in real time. When you’re following an active investment strategy, you may choose a portfolio based on a company’s earnings and track the benchmark index to decide when to buy and sell.

You may also use a smart beta exchange-traded fund system to select investments for your funds portfolio. As an active investor, you’re seeking short-term profit but you may need to trade stocks several times each day and keep a constant eye on your investments so you can make beneficial moves to increase profit.

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