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What Is Passive Investing and How Does It Work?

February 1, 2022
5
min

Passive investing is a strategy that can help people build wealth over the long term. Investors have faith that, over time, the market’s rise will provide gains.

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Passive investing appeared as an official strategy in the 1970s, when Vanguard Group founder John C. Bogle created a publicly available mutual fund. His Vanguard 500 Index Fund mirrored holdings in the Standard & Poor’s 500 Index, which was often seen as a stand-in for the stock market as a whole. The fund changed the game because regular investors could buy shares in some of the market’s best companies with little effort and upfront cash. Other companies soon offered their own versions of index mutual funds. 

Passive investing evolved further with the creation of the exchange-traded fund, or ETF, in the 1990s. These funds are designed to track various indexes, so they offer an easy form of diversification. Compared to mutual funds, ETFs tend to come with lower management fees and more liquidity.

What is passive investing?

Passive investing is a strategy that can help people build wealth over the long term. It’s based on the premise that buying well-diversified assets and holding them will produce an average market return. Instead of trying to outperform the market, sometimes through constant trading, passive investors do little buying and selling. A popular passive investing strategy is to buy broad market index funds and hold them for a long time. These investors have faith that although the stock market experiences highs and lows, it generally rises. 

Passive investing examples

Passive investing usually involves buying a fund that tracks an index, which can be cheaper and easier than researching and selecting stocks and making trades. In practical terms, that might mean buying a mutual fund or an ETF.  

Beyond securities, other passive investing examples include real estate, peer-to-peer loans, and funds that target an investor’s retirement date.

Passive vs. active investing

Passive investing contrasts with most types of active investing, which involves buying and selling in an effort to beat the market. Although a buy-and-hold strategy is often associated with passive investing, the length of time something is held doesn’t specifically determine whether it’s active or passive. Instead, the key distinction between active and passive investing is that active investors are engaged in the decision-making process about what to buy or sell and when, usually with the goal of beating the market, whereas passive investors farm out this process to someone else such as a robo-advisor.

For instance, an active investor may try to achieve better returns than the Standard & Poor’s 500 Index by picking individual stocks. A passive investor may buy an index fund that seeks only to match the S&P’s performance.

Unlike passive investors, active investors regularly monitor their assets and broader trends in the market. Using that information, active investors may swap out securities to try and beat the market. They may, for instance, take advantage of short-term price fluctuations and buy or sell to keep their portfolio’s asset allocation on track. Or, they can choose to hold their assets with the expectation that the value will eventually catch up and surpass the broader market.

The three key differences between passive and active investing are:

1. Level of effort

As the name implies, active investing involves a hands-on approach and making choices. An active investor can either research and select individual assets for their portfolio or buy actively managed funds. Passive investing is meant to be a simpler and cheaper approach, so this type of investor may buy passively managed funds or choose investments that require less work. For instance, they may purchase shares in an ETF that tracks the S&P 500.

2. Averages vs. timing

Because passive investing takes a longer-term approach, these investors know that market downturns generally average out with growth over years or decades. Active investors, on the other hand, may try to time the market by taking advantage of short-term gains. Both strategies may work in different circumstances. According to a 2021 Morningstar report, just a quarter of active funds outperformed their passive counterparts over a 10-year period. But in some sectors, active funds won out during certain years.

3. Taxes

Both types of investors are subject to taxes, but the passive approach may generate a lower tax bill. Long-term capital gains result from selling assets owned for more than one year, which tends to apply to passive investors with long-term horizons. These investors typically pay the long-term capital gains tax of 0%, 15%, or 20%, based on the investor’s taxable income level.

Selling an asset after owning it for less than a year—which active investors sometimes do—results in a short-term capital gain. Profits from assets sold within a year are taxed as ordinary income, with rates that range from 10% to 37%. Active investing also involves more trading, which can trigger more gains and drive up the tax bill further.

Potential advantages of passive investing

Some people may be drawn to these potential benefits of passive investing:

  • Lower costs. Passive investments involve fewer trades and less research, which holds down fees and expense ratios. As a result, passive investors spend less of their money on management costs.
  • Tends to be lower risk. There can be less risk of losing money with passive investments because they’re typically well-diversified and follow the market, which has historically experienced steady growth over time.
  • Tax efficient. Because passive funds have fewer trades, there are fewer capital-gains payouts. That often results in lower taxes.
  • Transparency. Investors who buy index funds will always know the asset composition of their portfolios.
  • Requires minimal effort. Compared to active investing, the passive approach vastly cuts down on the work involved because it requires less research and fewer trades.

Potential limitations of passive investing

It’s also important to consider the drawbacks associated with passive investing:

  • Requires time and patience. Passive investors typically hold assets regardless of the state of the market, so they’ll need to tolerate losses during periods of economic turmoil.
  • Potential to miss short-term opportunities for growth. Passive investments are usually positioned to match the market, not outperform it.
  • Less room for personalization. Passive investors are more likely to buy broad market index funds, rather than picking individual stocks, which limits customization. Investors who prefer a more hands-on approach may consider active investing.

The bottom line

Passive investing typically involves buying assets tied to market-weighted indexes and holding for the long haul. These investors have faith that, over time, the market’s rise will provide gains for those who wait. Passive investing lacks some of the excitement of active investing, in which investors select which individual securities to buy or sell, but it comes with lower risks and costs.

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