What is 'Passive Investing'

Passive investing is an investment strategy  to maximize returns by minimizing buying and selling.

BREAKING DOWN 'Passive Investing'

Passive investing methods seek to avoid the fees and limited performance that may occur with frequent trading. Passive investing’s goal is to build wealth gradually. Also known as a buy-and-hold strategy, passive investing means buying a security with the intention to own it long term. Unlike active traders, passive investors do not seek to profit from short-term price fluctuations or market timing. The underlying assumption of passive investment strategy is that the market posts positive returns over time.

Passive managers generally believe it is difficult to out-think the market, so they try to match market or sector performance. Passive investing attempts to replicate market performance by constructing well-diversified portfolios of single stocks, which if done individually would require extensive research. The introduction of index funds in the 1970s made achieving returns in line with the market 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.

Passive investing benefits and risks summary

Maintaining a well-diversified portfolio is important to successful investing, and passive investing via indexing is a good way to achieve diversification. Index funds spread risk broadly in holding all, or a representative sample of the securities in their target benchmarks. Index funds track a target benchmark or index rather than seeking winners, so they avoid constantly buying and selling securities. As a result, they have lower fees and operating expenses than actively managed funds. An index fund offers simplicity as an easy way to invest in a chosen market because it seeks to track an index. There is no need to select and monitor individual managers, or chose among investment themes.

However, passive investing is subject to total market risk. Index funds track the entire market so when the overall stock market or bond prices fall, so do index funds. Another risk is lack of flexibility. Index fund managers usually are prohibited from using defensive measures such as reducing a position in shares, even if the manager thinks share prices will decline. Passively managed index funds face performance constraints as they are designed to provide returns that closely track their benchmark index, rather than seek outperformance. They rarely beat the return on the index, and usually return slightly less due to fund operating costs.

RELATED TERMS
  1. Passive ETF

    A passive ETF is a method to invest in an entire index or sector ...
  2. Passive Activity Loss Rules

    Passive activity loss rules are a set of IRS rules that prohibits ...
  3. Suspended Loss

    A suspended loss is a capital loss that cannot be realized in ...
  4. Index Investing

    Index investing is a passive strategy that attempts to track ...
  5. Active Index Fund

    Active index funds track an index fund with an additional layer ...
  6. Active Management

    Active management consists of a human overseer or group making ...
Related Articles
  1. Investing

    5 Common Misconceptions About Passive Investing

    Be aware of these 5 misconceptions about passive investing when deciding between passive and active.
  2. Investing

    Why Your Passive Fund Is Crushing Active Managers

    A new study shows passive funds outperformed over 5, 10 and 15 years
  3. Investing

    A Closer Look at Passive Vs. Active Management

    Find out what the data has to say about the passive management vs. active management debate, and why there isn't necessarily a clear winner.
  4. Retirement

    Active vs. Passive Investing During Retirement

    How these two investing approaches work – and how to decide which best suits your precious nest egg.
  5. Investing

    Passively Managed Vs. Actively Managed Mutual Funds: Which is Better?

    Learn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
  6. Investing

    Why Its Sunset for Wall Street's Stock Pickers (JNS)

    Investors are abandoning actively managed mutual funds, hedge funds, ETFs and other vehicles at an accelerating rate in favor of passive funds
  7. Investing

    The Link Between ETF Popularity and Debt

    There may be a link between a firm's weight in bond indexes and how indebted that firm is.
  8. Investing

    How Investors Can Prepare for a Passive Investing Bubble

    A passive strategy in investments can create too much risk in your portfolio.
  9. Investing

    Funds with the Largest Inflows for September, 2016 (VTI, XLRE)

    As the third quarter drew to a close, investors continued to pour money into passive funds, while active funds battled heavy outflows.
  10. Investing

    4 Best Passive Income Investments

    Generating income from passive investments begins with knowing which ones are the best fit for your portfolio.
RELATED FAQS
  1. Who's in charge of managing exchange-traded funds?

    An exchange-traded fund (ETF) is a security that tracks an index but has the flexibility of trading like a stock. Just like ... Read Answer >>
Trading Center