The pros and cons of passive investing (2024)

Important: This article is for general guidance purposes only and should not be considered investment advice. If you are unsure about the suitability of an investment, please seek out advice. When you invest, your capital is at risk.

Passive investing is often framed as a strategy that’s focused on buying and holding low-cost index funds/ETFs or assets like stocks and real estate for the long term. The reason it’s ‘passive’ is because there’s usually little interference in terms of frequent buying or selling which should in turn minimise trading fees. In contrast, pursuing transactions based on perceived opportunities or in response to market conditions would constitute ‘active’ investing.

Described as a hands-off approach, passive investing takes comparatively minimal effort and has the potential to produce inflation-beating returns over the long term via compound interest. It does, however, also have some drawdowns.

You may be a passive investor already

Passive investing can start by acquiring a host of assets, including buying property, purchasing art, investing in businesses, owning dividend stocks or buying index funds. Regardless of the investment, however, there is one unifying element.

If you’re investing passively, there’s the assumption that you aren’t selling the asset soon after having purchased it. Instead, your plan to hold it for the long term.

How long is long term?

The timeframe of the passive investment strategy often depends on how long you have to meet a financial goal, like retiring comfortably or generating a deposit for a house. For some people, this might be five years. For others it’s 20 years or more.

As an example, a 20-year-old passive investor may have 40 to 45 years before they retire. Someone in their 50s, on the other hand, may only be planning to hold their passive investments for another 10 years. Whatever the timeframe, the main goal is to minimise selling then rebuying as this incurs additional fees.

What are the benefits?

Warren Buffett – the famed billionaire long-term investor – believes most people should be passive investors. Here’s his rationale:

• Fees stay low. When you’re buying and selling, you’ll pay fees for each transaction. The more fees you generate, the more money you need to make in returns to compensate for those fees.

• Built-in diversification. Index funds/ETFs, which are commonly used in passive investment strategies, often track major stock indexes like the S&P 500 or the FTSE 100. They usually offer exposure to hundreds or thousands of stocks, providing easy portfolio diversification. Diversification is good as it means you get a wide variety of investments within a portfolio. This may lower the risk compared to just holding one stock.

• Less time intensive. Most people lack the time, dedication or knowledge to consistently outperform the stock market indexes over many years. Even most hedge funds, which are run by professionals, can’t do it.

And the risks?

For more than 100 years, despite volatility and bear markets, stock market benchmark indices have tended to offer positive long-term returns. Depending on the index, the average ranges from a few percent up to about 10% or 11%. The S&P 500, for example, has averaged an 8% return since 1957.

Past performance, however, isn’t indicative of future returns. So, here are a few things to consider:

• Potential returns could be lower – even much lower – in the future.

• Averages can be deceiving. Making an average of 10% per year doesn’t mean making 10% every year. There is a large distribution of annual returns. Some years are very good, while others may see declines of 50% or more.

• It can sometimes take decades for the index or stock price to reach a prior high after a decline. Even with a 10 or 20-year time horizon, it’s possible a person could lose or make very little money over the time they intend to hold their investment.

• There is also the argument that passive funds’ popularity could be problematic in down markets. As more money flows into passive funds, more cash is pushed into the same stocks in the index. This, in turn, inflates the price of indexed assets and makes the declines bigger and harsher if they occur.

Passive or active – what should I consider?

Proponents of active management strategies would argue that they are able to take advantage of opportunities while also mitigating market risks that may be appearing on the horizon.

An active investment strategy, for example, may look to purchase stocks in certain sectors when market conditions suggest a favourable environment for these companies. If these were to make a short-term return, they could then be sold, and other assets could be snapped up.

On the other hand, active investors could look to trade out of riskier assets during times when markets trend downwards. The hope would be that, by avoiding losses during such periods, long-term returns would benefit. This would contrast with passive investors, who would typically leave their investments as is during these times and ‘ride out’ uncertain periods.

Although the rewards are potentially higher if you’re an active investor, pursuing this strategy requires more work and skill to overcome the additional fees of active trading.

What should you ask yourself?

It’s a personal choice whether you passively or actively invest, but here are some helpful questions to guide your decision making:

• How much time do I have? Passive investing takes up little time, whereas active management requires more.

• How much market knowledge do I have? Making higher returns than stock indexes is something even the pros struggle with. Consider what edge or strategy you have that will help you to outperform.

• Are average returns acceptable to you? A passive investor accepts what is offered. That could be good or bad, depending on the year. Active investors, on the other hand, try to exert more control over their returns.

• Are you willing to hold through the bad? Consider whether you can hold your investments through a 30% or 50% or more decline. Will you still be able to sleep at night with your investments down that much? If you can’t stomach the idea of ‘riding out’ that kind of drop, then you may wish to allow some active trading to control the drawdowns/losses.

• Do you have an approach in mind? Passive investment is generally good for individual investors, but it does require a commitment to be able to stick with the strategy for years, if not decades. Consider this when choosing an investment approach.

What can I invest in?

Passive investing generally means buying and holding, but there are several assets, investment products and strategies you can put into place to help you succeed. Here are some examples:

Index fund passive investing. This is one of the most popular passive investing strategies and involves buying a personally selected group of index funds/ETFs that follow a benchmark index, such as the S&P 500 or the Nasdaq 100. The funds will return close to what the corresponding indexes return.

Individual asset passive investing: With this approach, you decide how you wish to allocate your account, then buy individual assets, such as stocks, bonds, precious metals or other assets. In this case, you will probably be using no or few index funds in your portfolio and buying individual stocks and bonds you believe will perform well over the long term. This approach is generally going to be more research-intensive and requires, at least initially, a decent level of market knowledge.

Core-satellite passive investing: This approach involves having a core – or substantial chunk – of capital in diversified index funds/ETFs. These often include both stock and bond funds. The percentage of the account allocated to these is up to the individual.

The rest of your funds are used for seeking out higher gains, such as purchasing individual stocks or investing in more niche fund products – like ETFs focused on particular themes or sectors.

The investment products making up the ‘core’ provide market average returns, while the smaller niche ETFs or stocks, which are generally more volatile, offer the potential for increased returns. Of course, the ‘satellite’ positions also have the potential to lose more, reducing overall performance in tough years.

Capital at risk.