Passive Investments 101

As you seek out effective strategies for investing your money, the options available to you may seem complex or overwhelming. If you’re feeling unsure of your ability to pick good stocks for your portfolio and make timely trades, or if you don’t possess the time or inclination to take a more hands-on approach, take a closer look at passive investing.

What is passive investing?

Passive investing is a long-term strategy designed to slowly increase your wealth, according to Pam Kruger of Investopedia. It’s based on the historically substantiated assumption that the market will make gains over time, lifting your portfolio with it. With this approach, instead of striving to beat the market and strike it rich, your goal is to match the market’s growth. Rather than researching individual stocks, reacting to short-term shifts in the stock market, or trying to predict how it will change, your goal is to put together a strongly diversified portfolio that’s broadly representative of the market — and then hang on to it. With this “buy and hold” approach, you’ll typically do very little trading, and you won’t need to keep close track of market downturns or surges.

Which passive investment options are available?

If you decide to pursue passive investments, index funds are the most common instruments for carrying out this strategy. Index funds gather a wide range of stocks, bonds or other securities from companies listed in a specific market index, like the Dow Jones or the S&P 500. The goal of grouping these holdings together is to match the performance of the index as a whole over time. If you contribute to a 401(k) retirement plan through your employer, this is another type of passive investing. Many 401(k) plans give you the option of spreading your investments across several index funds at once for extra diversification.

What are some pros of passive investing?

Passive investing comes with several advantages, including lower risk. When you invest in index funds, you’re essentially purchasing tiny pieces of many different securities, so one poorly performing stock or bond won’t make or break your portfolio. Writing for Investopedia, James Chen notes passive investing is generally cheaper, too. Index funds aren’t actively managed by professionals, so running them is much less expensive — resulting in lower fees for investors. Passive investing typically involves re-investing dividends, so you’re also likely to incur lower capital gains taxes each year. Finally, passive investing is easier to grasp and takes less time to manage, because you don’t need to study individual securities or make frequent changes to your portfolio.

What are some cons of passive investing?

If you’re considering a passive investing strategy, this approach has some drawbacks to consider. According to Chen, you shouldn’t expect huge returns on your passive investments, as they are by nature designed to reflect the market, not beat it. Passive investments aren’t as flexible as active ones, either. Your holdings are widely spread out across an index, so you won’t be able to take advantage of hot individual stocks or leverage short-term market changes to your benefit. Finally, like all investments, passive ones aren’t free of risk — you’re still exposed to the fortunes of the market.

Whether you’re new to the world of investing or looking to make a change in your approach, a passive strategy is worth considering. Speak with your financial adviser to determine whether this popular investment approach is one that makes sense for your needs and goals.