Passive investing is a strategy for building wealth over the long term. It has emerged as a popular way “to compound your wealth without really making any decisions yourself,” says Christopher Seifel, a Titan investment manager. “The way that you can think about it is almost like a coffee-can portfolio, where you invest money and you come back in 30 years and your wealth is compounded.” For those who feel time is on their side—that is, they’ve got several years to buy and hold an investment—passive investing can be a strategy to increase their capital.

What is a passive investing strategy?

balanced across many asset classes, industries, market capitalization sizes, and sectors. A few examples of passive investments include real estate, peer-to-peer loans, and funds that track an index, such as an exchange-traded fund (ETF). After buying these assets, the investor typically doesn’t sell them, even during times of market turmoil. The investor holds the assets and regularly reinvests in them.

Instead of trying to outperform the market, passive investors believe that minimizing buying and selling will lead to greater long-term returns. They have faith that although the stock market experiences highs and lows, it generally rises over the long term.

This strategy can help minimize the mistakes investors make when they react emotionally to sudden moves in the stock market. It also requires little work and is typically cheaper than active investing, because passively managed funds usually have lower expense ratios and generate fewer trading fees.

Key characteristics of passive investing strategies

The goal of passive investing is to slowly build wealth over time instead of pursuing shorter-term gains. The key characteristics of this strategy include:

• Long-term outlook.

  Passive investors believe that, despite highs and lows, the market rises over time. Therefore, investors who use this strategy believe they can count on steady market gains.

• Low costs.

  Passive investors don’t engage in frequent buying and selling, which minimizes trading fees and other investment costs. Passive funds also tend to have lower expense ratios than actively managed funds. The average expense ratio across all passive funds was 0.12% in 2020, according to Morningstar data, compared to 0.62% for active funds.

• Diversified holdings.

  Passive investors tend to diversify their holdings by buying index funds or adding several types of long-term investments to their portfolios.

• Less risk.

  All investing involves risk, but diversification can help spread risk. Even if one asset in an individual’s fund declines, it shouldn’t affect their entire portfolio.
  

Types of passive investing strategies

There are several ways to approach passive investing.

1. Index funds.

   Index fund ETF or mutual funds are often a go-to for passive investors because they contain a mix of assets and carry lower costs. These are popular options because they’re often diversified across asset classes, industries, market capitalization sizes, and sectors. After buying a fund, the investor typically holds onto it for the long term, even during market lows, and will regularly put more money into the investment to help it grow.

2. Real estate.

   One could buy an investment property, collect rent, and sell later for a profit.

3. Robo-advisors.

   These are little more than computer programs that manage an investor’s assets. Although most robo-advisors let investors establish a risk profile, humans play almost no role in selecting which assets to buy. The goal is to match the market while minimizing costs.

Potential advantages of passive investing

These features of passive investing may attract investors:

• Low costs.

  Passively managed funds require less research and fewer trades, so they usually minimize fees and have lower expense ratios.

• Transparency.

  When a passive investment follows an underlying index, it’s clear which assets an individual’s investing in.

• Tax efficiency.

  Passive funds trade less often, generating fewer capital-gains payouts that can increase tax bills.

• Simplicity.

  Investors can buy and hold an index or set of indexes, which is simpler than constantly researching and trading assets.

Potential drawbacks of passive investing

The passive investing strategy does have drawbacks and limitations:

• Limited holdings.

  Passive investors often buy and hold a specific index or asset, no matter what’s happening in the market. This provides fewer options unless the investor decides to look into other offerings.

• Smaller potential returns.

  Passive investments track the market, so by definition they likely won’t outperform the market.

• Hands-off approach.

  Passive investments are typically under the control of fund managers, so there’s little room for customization and flexibility.

Passive vs. active investing

Generally speaking, the goal of active investing is to beat the market, while passive investors try to mirror what the market is doing. Active investors select the assets they’ll buy or sell, whereas a passive investor farms out the asset-selection process to someone else. The passive strategy often works, too. According to a 2021 Morningstar report, only a quarter of active funds outperformed their passive counterparts over a 10-year period. And in some categories, not a single active fund beat out a passive one. Both strategies may offer benefits in the right circumstances, though.

Consider some of the main differences between passive and active investing:

• Level of effort.

  The biggest difference between the two investment strategies is the level of effort involved. An active investment strategy requires a hands-on approach—investors can either manage their own assets or outsource the job to a portfolio manager, who often seeks investor input in buy and sell decisions. Passive investing involves less buying and selling, and these investors often buy index funds or a similar type of investment. Whenever the underlying index makes a change, the fund that tracks the index automatically alters its holdings.‍

• Averages vs. timing.

  Passive investors focus on long-term trends and on diversifying their assets, trusting that any losses will be offset by rising valuations over time. On the other hand, some active investors trade in an attempt to time the market.

The bottom line

Passive investing’s core principle is that, over time, the market’s rise will provide gains for those who wait. Passive investments also tend to outperform their active counterparts over the long term. Of course, investors don’t have to funnel 100% of their funds into passive investments and many use a combination of passive and active strategies.

Side note: if you're curious about how compounding could potentially affect your investment returns over a period of time, check out Titan's Compound Interest Calculator.