You might have heard veterans in personal finance talking about passive investments. You might have been advised to invest in exchange-traded funds (ETFs) or index funds; if you are keen on passive investing.
But, what is a passive investment?
Passive investing is a buy-and-hold-strategy. The security is bought with an intention of keeping it for many years. This investment strategy aims at maximizing returns over the long run; churning the portfolio to the lowest. It is done with an aim of avoiding fees and performance fluctuations owning from frequent trading.
This strategy is particularly chosen by investors aiming at wealth creation. This is because of the belief that market yields positive returns given enough time. Seasoned investor and CEO of Berkshire Hathaway Inc, Warren Buffett, follows the principle of passive management. He advocates keeping investments for ultra-long investment horizons and infrequent selling.
Active investing aims at outperforming the market. Fund managers of an asset management company spend a great deal in researching and analyzing the market. Hence, mutual funds are majorly actively managed. Passive investing, on the other hands, is investing in exactly the same securities in a proportion to the market index. The objective is not to outperform the market, but to replicate the market/ index ( Nifty or Sensex) closely.
So, the merits of passive investing include the following
1) Passive investing is more predictable -One can track the performance of Nifty and Sensex over a period of time. Hence, these indices are more predictable than a fund manager. With a history of the past performances, passive investment allows gazing into the capital market.
2) Passive investing is not as expensive as active investing-Active investing results in high operating expenses. So, it tends to be more expensive as higher fees are paid by the investor.
3) Majority of the fund managers fail to outperform the index-According to the efficient market theory in economics, asset prices fully reflect all available information. As the market becomes more informed and knowledgeable, it is reflected in the stock price. Also, most active managers tend to run concentrated portfolios. With fewer securities compared to broad market indices, the chances of underperformance are too high.
4) It requires little decision making- Since it closely matches the performance of the target index, it requires little decision making, investments and analysis. It results in lower operating cost lower fees to the investors.
5) Passive investing is ideal for financial planning- Passive investment involves little to less churning. It is preferred for long-term investment because it’s predictability makes it more reliable.
The type of investment strategy depends on your investment goals and risk tolerance. Passive investments are great for investors looking for low-risk investment and are not attached to the idea of seeking rapid gains.