What is 'Passive Investing'

Passive investing is an investment strategy that aims to maximize returns over the long run by keeping the amount of buying and selling to a minimum. The idea is to avoid the fees and the drag on performance that potentially occur from frequent trading. Passive investing is not aimed at making quick gains or at getting rich with one great bet, but rather on building slow, steady wealth over time.

BREAKING DOWN 'Passive Investing'

Also known as a buy-and-hold strategy, passive investing involves buying a security with the intention of owning it for many years. Unlike active traders, passive investors are not attempting to profit from short-term price fluctuations, or otherwise "time the market." The basic assumption that underpins a passive investment strategy is that the market generally posts positive returns given enough time.

Passive Investing Strategy

Traditionally, passive investors attempt to replicate market performance by constructing well-diversified portfolios of individual stocks, a process that can require extensive research.

With the introduction of index funds in the 1970s, achieving returns in line with the market became much easier. In the 1990s, exchange-traded funds, or ETFs, that track major indices, such as the SPDR S&P 500 ETF (SPY), simplified the process even further by allowing investors to trade index funds as though they were stocks.

Now that mutual funds and ETFs allow for index investing with relatively little initial research, the most difficult skill for passive investors to master is emotional control. Resisting the urge to sell when the market experiences a downturn requires patience and a strong stomach. When a rapid sell-off triggered circuit breakers that shut down trading in August of 2015, for example, iShares Core S&P 500 ETF (IVV) and many other ETFs tracking the S&P 500 suffered significant losses, as investors panicked at the lack of pricing information and liquidated their holdings.

Passive investors must have the presence of mind to weather these storms and trust that the market will correct itself with time.

Testing Passive Investing

A highly vocal defendant of passive investing is value investor Warren Buffett. His approach as Chairman and CEO of Berkshire Hathaway Inc. (BRK-ABRK-B) exemplifies some of the principles of passive management, including ultra-long investment horizons and infrequent selling. In a sense, however, he is an active investor, since he invests in companies based on particular competitive advantages.

While his style of investing cannot be considered fully passive, Buffett is a big proponent of index investing. In 2008, to prove the superiority of passive management, Buffett challenged the hedge fund industry – the quintessential active investors – to a 10-year contest. He put a million dollars in Vanguard's S&P 500 Admiral Fund (the first index fund available to retail investors), while Protégé Partners LLC, the hedge fund that took him up on his challenge, picked five fund of funds.

Though the bet is still running as of 2016, Buffett's passive strategy has proven its worth thus far. By the end of 2015, Buffett's passive bet had generated a 66% cumulative return compared to Protégé's 22%.

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