Passive investing is an approach to investing that combines two purposes simultaneously: Maximizing investment returns over the long run and keeping in check the high investment costs by minimizing transactions in the investment portfolio. The two purposes are not mutually exclusive. Frequent trading within the portfolio can run up expenses and decrease overall returns.
Passive Investing with an Indexing Strategy:
Index investing is one of the principal techniques used by investment managers when focusing on a passive investment approach. An index fund is a pooled investment such as a mutual fund or exchange traded fund (ETF) whose composition mimics a particular stock index such as the S&P 500 or Dow Jones Industrial Index. Index funds are not restricted to US benchmarks. Indeed there are also index funds for international and global indexes. Furthermore, index funds are not restricted to stock investment; there are bond index funds as well.
Index investing was made popular by the Vanguard Group, a mutual-fund firm known for conservative, low-cost funds. Your choices are by no means restricted to that firm. Today, many investment companies offer low-cost, broadly diversified mutual funds and ETF’s as important components of their offerings.
Keep Your Costs Low:
Keeping costs low is one of the main advantages of investing passively with index funds. Buying and selling within an index fund is generally done only to maintain the investment portfolio’s weighting approximate to its benchmark index. Consequently, transaction costs are ultra-low.
Diversification and Passive Investing:
A second, equally important objective of passive investing is diversification. It is the answer to the old adage “Don’t put all your eggs in one basket.” Index funds commonly have many tens to hundreds of securities in their portfolios at any one time, making the effect of one company’s bad news minimal to the overall portfolio.
Tax-efficiency of Passive Investing:
Most index funds are highly tax-efficient. The relative infrequency of trading means that lower capital gains are realized each year relative to actively managed portfolios. By law, these gains must be passed on every year to the fund shareholders. If held in a non-qualified retirement account, these gains add to the holder tax liability each year. Passive investing inherently limits these pass-through gains, making tax time less costly for index investors.
Perfect for Arm-chair Investors:
Many folks are not high-powered investment managers and they know that. They want to participate in the market and build for their retirement but don’t want to get into the nuts and bolts of active investing. For investors like these, the passive investing approach using index funds is built-to-order.
Using index funds and ETF’s as the core of a long-term investment portfolio makes sense for many investors. Investor-advocate organizations such as Morningstar generally extoll the virtues of passive investing. The broad diversification, tax efficiency and low costs inherent in passive investing make sense for many folks desiring to achieve good returns on the investment of their hard-earned money and who may not be interested in more active forms of investing.