What is passive investing?

Learning to invest can be intimidating if you’re just starting out. I encourage you not to be discouraged if you’re not sure what to do at first or feel like you can’t be bothered.  When I first started, I also had no clue what I was doing.  Thankfully, my thirst for knowledge was greater than my fear. Today, I have far more knowledge than the 18-year old kid who bought his first mutual fund some time back now. Over the next month or so, my focus for the blog will be on investing.

My goal is to provide you with the basic essentials to help you better understand the market and your investments.  I’ve already written about the emotional discipline required for successful investing on previous posts. It would be beneficial and helpful to you to re-read these past articles (found in investing section of the site) in addition to what I will be discussing over the next month.

There are two primary ways to invest; actively or passively. Each approach has its advantages and disadvantages. For this post, I will be reviewing the passive approach to investing.

Strategy Overview

Passive investing aims to replicate the return of a benchmark index such as the Standard & Poor 500 (S&P 500) or Toronto Stock Exchange (TSX). Okay, I know that’s sounds like a lot of financial gibberish. I describe it that way first to ensure you’re able to recognize how the professionals define and describe it.

Here’s what that first sentence is basically saying. The Toronto Stock Exchange is Canada’s main stock market exchange. This is where all the major publicly traded companies in Canada shares can be bought and sold. The group of companies returns can be tracked individually, collectively, or both. The collective group of companies and their return is referred to as the index return. There are many indices around the world. For example, the United States has the S&P 500 index and Nasdaq index, while in Canada we have S&P/TSX Composite index to name a few.

If someone is using a passive approach as their method of reaching their investment goals and objectives. They are simply trying to replicate the return of the collective group of companies found on particular stock exchange or index. In Canada, they would be trying to replicate the return of the companies found on the Toronto Stock Exchange.

The way the investor achieves this is fairly straightforward, at least in theory. The investor would buy every single company stock that makes up the Toronto Stock Exchange. In doing so, they hope to then replicate the return the exchange will have since they hold the same identical set of stocks. The investor would sell and buy based on companies being added or removed from the exchange not based on what he or she believed was the best company.

The primary goal of a passive investor is not the out-perform the stock exchange return, rather their goal is to replicate the exchange return minus any fees they might incur to replicate the exchange return.

Why pick a passive investment strategy?

An investor who picks a passive strategy over an active one believes that market is efficient. They believe the market has already factor in all the relevant information available about a company or market. Therefore, there isn’t any real advantage to spending additional resources trying to get an edge over the market as the price reflects all the relevant information available. Passive investors believe over the long term it’s hard for an active strategy to outperform the market.

Passive investing is also attractive to investor’s who are looking for less of a hands-on approach to their investment. A passive investor requires less daily research since you’re simply taking the market return of whatever index your tracking. They believe the market return over the long run will be sufficient to meet their investment goals and objectives.

What are the advantages and disadvantages of passive investing

Here are some of the advantages with passive investing:

  • Lower fees compared to an active strategy
  • Fairly simple to start up
  • Success is based less on the investor’s abilities
  • Chances of underperforming the market is low
  • Lower trading fees
  • Less portfolio turnover

Here are some of the disadvantages with passive investing:

  • Returns of the benchmark or index might not be enough to meet your investment goal or objective
  • It can underperform an active strategy
  • No guarantee the returns will match the benchmark or index return
  • It lacks excitement (you don’t trade as often, which means less stock talk at parties)
  • Less direct control over specific investment holdings
  • Harder to take advantage of market opportunities

A passive investment strategy offers an investor a fairly straightforward way to invest in the market. The fees associated with a passive strategy are lower than those associated with an active strategy.  A passive strategy can be used for both equity (stocks) and debt securities (bonds). The most common way to invest passively is through an index mutual fund or an exchange-traded fund (EFT).

The important thing to remember about this strategy is you’re buying everything in the believe that over the long-term markets operate efficiently and your biggest barrier is cost and you. Therefore, a passive strategy keeps the cost low, moves you out of the way of your own success while letting the market do its thing.