Over the past few years, the idea of passive investing has really started to gain in popularity. But what exactly is passive investing and is it some new strategy to beat the market? Below you will learn everything you ever wanted to know about passive investing.

Passive Investing Defined

If you know what passive income is, then you have a good idea of what passive investing in. If you are not familiar with passive income, it is a way to earn money without actually working. For example, when you go into to your place of employment and get paid, that is considered to be active income. You are an active participant in earning the money. If you do not show up, you do not make money.

Passive income is the complete opposite. Think of the money in your savings account earning interest. You did nothing other than put the money in the account. You earned money regardless of what you did, even when you slept!

Most investments are considered active investments because portfolio managers are trying to beat the market. They are researching stocks every day, buying and selling trying to outperform an index.

A passive investment then is simply an investment in the market or index itself. There is no portfolio manager researching stocks, buying and selling everyday. The investment simply holds the same underlying investments that the index does. Whatever the market earns, you earn.

So Why Choose Passive Investing?

You may be wondering if you can choose to earn a higher return than the market, why would you not do that and ignore a passive investment? This is a great question. The reason why more investors are choosing to go the passive investment route is because no one can consistently beat the market.

You will find some portfolio managers that do beat the market in a given year. The problem is that they do not do it consistently. So why not just change your investment each year? This too is a great question and many investors try to do exactly this. But it does not work because you do not know what funds will beat the market until the year is over. So basically, it is a crapshoot as to whether or not you beat the market when you invest in actively managed funds. Here is a great study from Dalbar showing that the average investor (someone that tries to beat the market)

only earns 2% per year.

Another Factor For Choosing Passive Investing

There is one other thing you need to understand about active versus passive investing: the costs. I will go into greater detail about this in an upcoming post, but for now, understand that when you have a portfolio manager running a fund, that person and his team needs to get paid.

Their pay is funded by the management expense that the fund charges you annually. Because of this, actively managed funds tend to cost more than passively managed funds.

The typical equity mutual fund that is actively managed charges a management fee of 1.40% per year. This amount might sound small to you, but over time, it adds up. Again, I will talk about this in more detail in a future post.

Final Thoughts

The overall takeaway from this post is that there are two styles of investing: active investing and passive investing. Active investments are trying to earn a higher return than the market while passive investments are simply trying to earn what the market earns.

Since active investments do not beat the market on a consistent basis, it makes more sense to just take what the market gives you and invest passively.