Why Passive Investing Isn’t Passive at All: A Closer Look

By Nest Wealth on 09/05/2018Article 5 Minute Read

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People invest in the stock market for many different reasons: their child’s education, that snowbird getaway them and their spouse keep dreaming of, or having enough cash to comfortably retire. Now more than ever, we have so many investment options available at our fingertips, but with more investing solutions comes a more complex global market to understand and a much harder time deciding which option best suits your needs.

There are two main approaches used to invest: passive and active investing. So what do they mean? What are their main differences? Here we’ll discover the myths of passive investing and help you understand what makes them so different.

Passive Investing: “Being The Market”

By definition, passive is the state of being an inactive participant, but make no mistake about it, passive investing is not passive at all. Passively managed funds are referred to as “index funds” because they’re tied to an index that represents a particular market.

Three Passive Principles:

  1. Investments that are similar to a market index
  2. A Portfolio Manager picks stocks to look like a market index
  3. Low Fees

The thing with indexes is that you can’t actually directly invest in one of them. That’s why passively managed index funds exist. They track and mimic the movement in the index by investing in all or some of the securities held in that index. How else can we explain this? With passive investing, your money is used to buy shares in a category of companies and that category is called an index. If that category of companies collectively performs well, so will the index and you will see the direct benefits of that in your account (and the finish line for your goal).

There’s little to no human emotion involved because you’re relying on the historical performance of a market index.

As an investment strategy, passive investing aims to maximize returns over the long run. It also intends to keep the amount of buying and selling to a minimum. The idea is to avoid the fees and the drag on performance that could potentially occur from frequent trading. Passive investors aren’t trying to profit from short-term fluctuations in the market. Instead, they believe that the markets will deliver returns over time.

Active Investing: “Beating The Market”

Not to be Captain Obvious, but active investing is the opposite of passive investing. The idea of active investing comes from the belief that buying and selling more frequently will “Beat The Market” and generate better returns.

Three Active Principles:

  1. Investments that are different from a market index
  2. A Portfolio Manager picks stocks they believe will increase in price
  3. High Fees

Active investing relies on skills and experience. So how does it work? Well, you would essentially give your money to a manager whose main goal is to outperform (or beat) a certain index, but that doesn’t always happen. Depending on the manager’s success, they may provide more (or less) return than a relative index. Because the market may not always behave according to the manager’s plan, there’s more room for human error. Since active managers are really hands-on and dealing with a great amount of stress to try and get you the best return, this type of investing approach tends to be a lot more costly by comparison.

An Active Comparison

Despite the inherent connotations involved with its name, this Bloomberg article suggests passive investing is trending as the more favourable investing style. Another selling point of passive investing is its low cost. Investors can take advantage of lower fees and give you access to the diversification of key markets.

Overwhelming research suggests that passive investing outperforms those that are trying to beat the stock market. Using this as our own foundation, we build your portfolio to ‘be the market’, rather than try to ‘beat the market’. The best investors in the world, including Burt Malkiel, Jack Bogle, and David Swensen, are in it for the long term. To increase their chance of success, they focus on proper diversification, systematic re-balancing, appropriate risk and reducing fees. This means that not only are you getting a better-constructed portfolio at a lower cost than a traditional fund, but you are also likely to outperform most mutual funds over the long run.

“The only remaining problem for ‘passive’ investing is the name. Why don’t we all agree on a single change and call indexing success investing?” -The Power Of Passive Investing: More Wealth with Less Work

So, do your research before narrowing in on your investment strategy. And don’t let the name fool you: choosing to passively invest does not at all make you a “passive” investor. Be sure to do your homework when deciding if passive or active investing is best for you.