Passive Investing: Why It’s the Easiest Way to Build Wealth

Investing is how most of us will build wealth, not through our jobs, an inheritance, or winning the lottery. But not everyone has the time or the inclination to put together an investment strategy and then manage their portfolio. And even if we did, how successful would we be? We’re not an investing professional; we’re primarily laypeople or at best, enthusiastic money nerds. We have two choices; use a professional portfolio manager or passive investing.

Active managers are investment professionals; using one will surely increase your market returns compared to making every investment decision yourself or using a passive investment strategy, right?

Not according to a recent analysis by Morningstar:

Only 23% of all active funds topped the average of their passive rivals over the 10-year period ended June 2019.

We don’t have a problem with paying for results, but active management costs money, sometimes lots of money:

The average expense ratio for actively managed mutual funds is between 0.5% and 1.0%. For passive index funds, the typical ratio is about 0.2%.

And as you saw above, those higher expense ratios don’t often come with results. Those percentages may look small on paper, but over time, they can take a big chunk of your money.

The choice seems clear, passive investing it is. But before we make any decisions, let’s take a deeper look at passive investing.

What Is Passive Investing?

Passive investing means you buy and hold, you’re investing for the long haul. Passive investors aren’t continually buying and selling, which makes this method of investing low-cost compared to active trading.

The best example of a form of passive investing is index funds. These follow a major index like the S&P 500 index or the Dow Jones index.

When an index sheds or gains one of the stocks that are traded on that index, the index funds that are mirroring it do the same.

They sell the stock that’s leaving the index and buy the one that’s coming on board.

When you invest in an index fund, you own a tiny amount of numerous different stocks. You make money when those stocks, which represent a wide swath of the whole stock market, increase in value.

And yes, you lose money when those stocks lose money.

But remember, passive strategies are long-term, and over a significant period, the ups and downs come out in your favor.

Passive vs. Active Investing

Passive investing is hands-off and long-term. Active investing is the opposite. Active investors need a portfolio manager, whether that’s a financial advisor, fund managers, or you.

The end game for an active investing strategy is to beat the average return of the market and capitalize on the short-term ups and downs.

Doing this requires a lot of information, much more than a portfolio manager could do on their own, so they work with analysts who deep dive into stocks and other asset classes to try and figure out when those ups and downs will happen—timing the market.

These people think they can determine the exact right time to buy and sell.

Types of Passive Investments

If you’ve been an LMM listener or reader for a while now, you’re already familiar with various forms of passive investments since passive funds are our preferred method of investing, including index funds, as described above.

But there are other passive investments too.

Robo Advisors

If there is one area of life for which we welcome our robot overlords, it’s investing. Robo advisors use computer algorithms to create portfolios, set asset allocation, rebalance, and perform tax-loss harvesting.

This investing strategy requires no human intervention, which means low or no minimum investment and low fees for investors.

Betterment and Personal Capital are examples of robo advisors.

ETFs

ETFs are Exchange-Traded Funds, a fund that can be bought and sold on an exchange like a stock. An ETF allows passive investors to buy a whole basket of assets at once rather than putting individual securities into the basket one by one.

The owner of the ETF owns the underlying assets and creates a fund to track the performance of those assets and sells shares in the fund to investors.

Those investors own a portion of the ETF but don’t own the underlying assets.

ETFs are designed to track the value of an underlying asset, a basket of stocks like the S&P 500, for example, and they trade at prices determined by the market, but those prices typically differ from that asset.

An example of an ETF is the Vanguard FTSE Emerging Markets ETF, which is a passive investing product and passively managed as nearly all ETFs are.

Pros of Passive Investing

Even for those of you who are dedicated DIYers, there are lots of reasons to choose a passive investing strategy.

It Makes Financial Sense

Passive management has lower fees than active management. Cheaper isn’t always better, but in this case, it is. We provided some stats on the outperformance of passive investing when compared to active investing above.

It Saves Time

Not many people would list investing as one of their hobbies, and even if it was their hobby, that doesn’t mean they have enough time, knowledge, and resources to do the amount of research required to become a mini Warren Buffett.

You don’t need to do much research to become a successful passive investor. You don’t need to know stock prices, interest rates, P/E ratios, or any of the other information to make an informed decision when choosing stocks for an investment portfolio.

You could spend an hour or two reading about the various ways to invest passively and which provider to use once you’ve decided how to invest and be done with it.

It’s Easy

You can start investing passively in less time than it takes to read this article. To use a robo advisor, for example, typically requires you to answer a few questions about your financial goals, your time horizon, and your level of risk tolerance.

Based on your answers, you’ll be recommended a portfolio that best suits your needs.

You don’t even need to really know what in the hell a stock is!

Cons of Passive Investing

While we love and recommend passive investing, it isn’t without its drawbacks.

Your Money Is Tied Up

When you use a passive investment strategy, you’re committing to long-term investing. What’s long-term? Ten years or more.

That means your money isn’t terribly liquid. There aren’t penalties for pulling money out (unless the money is in a retirement fund), part of what keeps passive investments low cost is long-term investing has fewer transaction costs.

Timing

Even if you understand that you’re investing for the long haul, emergencies happen. If you need to pull money out of your investments for an expense that cannot wait, you can only hope that the market is doing well.

Just because you’ve left your money invested for many years or even many decades is no guarantee that when you need it, things will be in your favor.

Imagine how many losses you would have realized if you had to pull money out of your investments during the COVID-19 crisis.

Diversity

While a passive investment strategy can be diverse, it might not be diverse enough. Mutual funds, index funds, and ETFs allow you to invest in various securities across a wide swath of the market. However, you might be missing out on other kinds of investments, often called alternative assets.

To truly diversify your investment portfolio, you need to seek out other classes of assets collectively named alternative investments.

We love rental properties as a form of passive income. How passive depends on how involved you wish to be with your properties and tenants.

You can handle everything yourself or turn all aspects over to a management company that allows you to write and receive a check each month.

If you’re uninterested in becoming a landlord, you can still add some real estate to your portfolio easily and affordably with a REIT (Real Estate Investment Trust).

You can potentially make great returns by delving into peer-to-peer lending. How do banks make money? By making loans and charging interest on those loans.

Peer-to-peer lending makes you the bank, and you make money the same way.

These are just a few of the alternative investment options that sticking to the typical types of passive investment options mean you’ll be missing out on.

Don’t Pass On Passive Investing

If you’re brand new to investing and feeling a little intimidated by it all, passive investing is the best way to dip your toes into the water.

Passive investing can be the gateway drug to more complex forms, or it can be your only foray into investing. Either way, you can use it to become successful.