As new investor, you may not have much free time to dig into a company’s earnings to see how they have performed over the last quarter and what the future holds. You also may not have robust risk management place to deal with sudden movements in the market across asset classes.
One investing strategy you can apply here is a passive investing strategy. Passive investing has gained more traction over the past few years as financial instruments such as ETFs and Index fund have allowed less sophisticated investors.
What is Passive Investing
Passive investing generally refers to buying and holding assets over a long period of time with little trading in the market during that time. Trading in this sense means you hold that position and where the opportunity to buy more of the asset comes up, you do so.
An example of passive investing is a when an individual purchases an Index Fund or an Exchange Traded Fund (ETF) after doing research (one would hope) and hold that investment for a long period of time.
A long period of time is relative to the investors but with Passive investing you are looking at between three years and ten years if not longer. The aim here is to minimise the transaction costs associated with buying and selling on your portolio return.
A passive investor is someone who buys a security with the intent on holding it for a long period of time as opposed to an active investor who would get in and out of multiple trading positions in a shorter period of time. A passive investor does not try to time the market or make any decisions based on short terms price movements in the market or asset classes.
What is the Best Passive Investment
With passive investments the aim is to reduce cost, reduce fees while you see more transparency, tax benefits and simplicity.
The most common asset classes for Passive Investors from a stock market point of view are Index Funds and ETFs. Passive investing as a whole can include real estate, dividend paying stocks and other activities however we are looking at this from a stock market point of view.
Investing in a Fund or ETF that tracks the market is one of the best ways to benefit from the performance of the companies that constitute that index or fund without having to do much research into the individual companies or pay fees for trading the shares in either one of the individual companies.
ETFs are Exchange Traded Funds that track certain markets or are made up of different stocks with different weightings allowing you to benefit from the performance of those companies.
Benefits of Passive Investing
Passive investing has a number of benefits hence its appeal to many investors how have chosen to adopt that method. Let us consider these benefits in more detail.
Low Fees
This is arguably one of the main appeal of passive investing from a stock market point of view. Each time you buy or sell, your order needs to be executed and whoever executes that order on your behalf for example your broker, will charge you fees and even if they do not charge for executing your orders, there are other fees involved.
With passive investing you are not looking at the earnings report of hundreds of companies, you are not paying for research and all these costs add up and affect your returns. This link has details of what Active Investing is and the associated costs.
Tax Efficient
Passive investing is more tax efficient than active investing because of capital gain tax which is that tax you pay on your earnings. If you have not sold your position, you have not realised your earning and thereby exempt from Capital Gains Tax. There are other tax effective benefits of passive investing.
Simplicity and Clarity
As a passive investor when you invest in an Index Fund or ETF, it is easy to see what companies are being tracked and what the weighting is. The assets in the fund are visible and can be seen at any time.
You will not need to carry out research on all the companies in the fund and there is no need to constantly research and adjust your holdings of a particular stock or asset.
Lower Risk
Passive investment where the investment is made in some sort of tracker fund or ETFs are considered to be lower risk compared to active investing due to the diverse nature of the fund. If you invested a 100% of your portfolio in a number of tech stocks, the risk is higher due to the fact that these companies can go bust or be subject to price fluctuations in a short space of time.
With a Fund, there a numerous companies being tracked if not hundreds of companies and although we never say never, the chances of those companies going bust at the same time or many of them being subject to price fluctuations in a short space of time is a lot less.
Cost
The cost of a single share in Apple, Amazon, Netflix, Facebook and Google to name a few is high especially for a new investor and any movement in the price can have real impact on the overall portfolio.
However if you bought an ETF that tracked Tech stocks above, you will pay a considerably less amount of money to own that and have the opportunity to benefit from the performance of those stocks.
Disadvantages of Passive Investing
There are a number of drawbacks with Passive investing and here are the most common.
Lesser Returns
With passive investing you are likely to get a lower return compared with an active trading strategy because although you survive volatility in the market, the low risk nature of investing in Funds also means lower rewards.
Sometimes a single stock in an index can produce a higher return than the whole index and a passive investment strategy will miss out on that opportunity.
As a passive investor in an Index that tracks the market, you are the market in some way and active investors are looking to beat the performance of that index so your performance in a sense is the market performance.
Not Dynamic
Unlike active investors who can react when there is an event in the market to minimise their risk or take advantage of a new opportunity, Passive investors do not have that liberty.
If a particular stock in the benchmark will not perform well, the index fund manager cannot sell that particular stock or remove it from the index in such a way that it does not affect performance. You pretty much live and die by the Index.
Example of Passive Investing
Putting it all together, let us consider this example. I am a passive investor with a certain amount of money and in true passive investments style, I have purchased a number of Funds.
Based on research and where I think the market is headed, I have allocated my portfolio in the following way.
- 25% in a Crypto ETF BLOK. Click the Link for the chart.
- 25% in QQQ an ETF that tracks the S&P 500. Click the Link for the chart.
- 25% in a Marijuana ETF. Click the Link for the chart.
- 25% in a fund that tracks the S&P 500. Click the Link for chart.
I buy and hold these positions until I choose to sell them, hopefully many years after I have bought them. Worth nothing in the example above I have allocated 100% of my portfolio equally across four financial instruments.
Now let’s say Cryptocurrencies and Marijuana (interesting combination there) are gaining traction, becoming widely accepted, and all the good stuff. I should see my position or investment go up in value as more companies invest in this as policies that are friendly to these causes are enacted.
In a situation where policies change, or Cryptocurrencies are outlawed and marijuana is considered taboo, the market will react in a negative way most likely and the value of my investments will fall.
As a passive investor, I am have those positions and the only way out is to sell them (this is not strictly true and there are ways to hedge but for the purpose of this example it is true) or wait for the situation to change in such a way that the prices start gaining – perhaps the law makers realise they were wrong and we all fall in love again with cryptos and marijuana.
Final Note
Passive investing is an investment strategy that suits the investor who wants to save time, save money and their blood pressure in some cases so they are not constantly looking at the market to see how particular companies are performing.
Whilst you will save money in terms of transaction costs, research fees and capital gains tax, as a passive investor you may not enjoy the full benefit the market has to offer especially in situations where a new opportunity reveals itself.
You will however enjoy the benefit and relative safety from diversification because of the financial instruments you purchase and how they are structured to track an Index or a number of companies in a particular sector or region.
Passive investments like active investments have their benefits and draw backs and in many cases it is better to adopt a strategy that applies both.
