Have some cash to put away for a rainy day or your retirement? To make your cash earn some extra money you should invest it carefully. Passive investing is one way of making your money work for you.
What is passive investing?
First of all, what is the definition of the term passive investing? Let’s get to grips with this.
Well, the term passive investing refers to a broad range of specific types of investment strategy, in which you aim to maximize your returns by minimizing how much you buy and sell.
In one well-known and common passive investment strategy, called index investing, an investor buys a representative benchmark and holds the benchmark for a long period of time.
Passive investing can be seen as the opposite of active investing, a more tedious and hands-on style of investing, in which you must ensure that you time the market just right.
What is the strategy of passive investment?
So, as we touched upon earlier, in passive investing, you basically try to boost your returns by buying and selling less. But, that’s not all there is to passive investing.
Another facet of passive investing methods is that these methods have been developed to avoid the limited performance and fees that often come with frequent trading; the aim is to build wealth more gradually. In passive investing, you buy security intending to own it long-term. This might be why passive investing is also sometimes known as the buy-and-hold strategy.
This method is in stark contrast to active trading, where investors aim to profit from market timing or a short-term price fluctuation. Instead, passive investing assumes that the market should surely yield positive returns over a long time.
Unlike with active trading, a passive investor’s view is that it is too hard to try and out-smart the markets, so instead, such an investor tries to copy the sector’s or market’s performance with their passive investments. A passive investor does this by putting together a diverse portfolio of single stock passive investments.
What are the pros of passive investing?
Having a well-diversified portfolio is imperative for a good investment in general, no matter what style you are using. But, passive investments give you a very easy way to achieve this diversification.
What’s more is, passive index investing is also one of the cheaper and less complicated forms of investing. Passive index investing spreads the risk evenly because you hold either a representative sample or, all of the securities in their target benchmarks. Your index funds will track either an index or a target benchmark, so passive index investing doesn’t involve the constant buying and selling of securities. Because of this, passive index investing has far lower operating expenses and fees, compared to actively managed funds.
Passive index investing is also an easier and simpler way to invest in a chosen market since it only tracks an index. There is also no need to choose investment themes or select and monitor individual managers.
What are some of the cons of passive investing?
Of course, passive index investing is also subject to total market risk. Your passive investments track the entire market, which means that when the overall bond prices or stock market falls, so will your passive investments.
Another pitfall to look out for is the lack of flexibility in passive index investing. The manager of an index fund is typically disallowed to employ protective measures like reducing a position in shares, even if they think that the share’s price will decline.
Passive investments also face performance constraints, since they are designed only to provide returns that precisely track their benchmark index, rather than to outperform. As a result of this, passive investments hardly ever beat the index’s return and generally return slightly less because of the fund operating costs.
So, what about corporate-owned life insurance?
If these cons have put you off passive investing, one alternative investment option is corporate-owned life insurance. This is a product that is great for business owners.
Traditionally, the retained profits and surplus cash a business has get invested in taxable investments. This does allow a business to benefit from low corporate tax rates on active business income, but eventually, these assets will be taxed at high dividend tax rates.
However, corporate-owned life insurance is a tax-effective way for a wealthy individual to accumulate passive wealth within a company, access it tax-free, and move it tax-free to their surviving beneficiaries. Check out WEALTHinsurance.com for more on this.
What about active investing?
If you are still interested in finding out more about some other investment options, one of these is active investing.
When it comes to active vs passive investing, active investing is the investment style that affords the most flexibility. This is because the managers of active investments are not obliged to follow a specific investing index. Instead, these managers can buy any stocks they like, including whatever one in a million stocks they feel like they’ve found.
Managers of active investments are also able to hedge their bets, with many techniques, like put options, or short sales. Active investment managers are even able to leave specific stocks and sectors when the risk gets too big. But passive investment managers are always stuck with the stocks of the index track they are holding, no matter what the ups and downs are.
Active management advisors can even set up a personalized tax management strategy for an individual investor, like selling the investments that are losing money, to pay for the taxes on other investments that win big.
So when you consider active vs passive investing, active is certainly the more flexible, less limited, and sometimes more immediately lucrative option.
What about the cons of active investing?
But it’s true that active investing also has some big pitfalls that keep the strategy from being appropriate for everyone. So, what are some of these downsides?
Well, the main disadvantage of active investing is that it is, of course, extremely expensive. According to Thomson Reuters, the average expense ratio for an actively managed equity fund is around 1.4%, whereas the typical expense ratio for a passive equity fund is a mere 0.6%!
Why are those fees so high? Well, it’s mainly because all the active purchasing and selling triggers big transaction costs. But as well as this, you are also paying for the salaries of the analyst team, who have to research those equity picks. Over the decades, all these fees can completely nullify your returns.
Another big pitfall with active investments is the risk. The manager of an active investment has complete freedom to buy whatever investment they think would bring the highest returns. Brilliant when the analysts are correct, but awful when they get it wrong.
And then there’s the established poor track record associated with active investing. Hardly any actively managed portfolios actually manage to beat equivalent passive benchmarks, particularly after you consider the fees and taxes!