Not everybody has the time for managing an equity portfolio. Understand and researching the financial markets for fruitful stocks to purchase is not only time-consuming, but requires experience and patience. For many Americans, it is simply not feasible to actively manage an investment portfolio. However, everyone wants to grow their money as the economy grows, right? Passive investing allows anyone to grow their wealth as the market grows over long periods of time. Rather than actively seeking worthwhile investments, one can buy index or mutual funds in their 401(k) or investment portfolio. Holding such funds long-term will yield great profits as the broader economy grows.
What is passive investing?
Passive investing is when an investor buys a market-basket index, such as the SPY index fund that tracks the S&P 500 index. This index will be highly diversified among industries, and will have a portfolio makeup that resembles major stock market indexes (Dow Jones, NASDAQ, S&P 500).
Passive investing is incredibly easy to do. All one needs is a brokerage account, with any major brokerage such as Charles Schwab or Fidelity. Then, one must purchase an index fund, such as the SPY S&P 500 fund or the VFINX Vanguard 500 index fund. There are a variety of funds, with varying levels of risk. It is very easy to do research on funds.
The main justification for passive investing is the “Efficient Market Hypothesis.” This theory effectively states that stocks are priced fairly, as they must reflect all the knowledge about each company that is available. Therefore, there is no point in trading stocks in the short-term to try to outperform the overall market. Only in the long-term, with new products and growth opportunities, will stocks grow.
Why invest this way?
Passive investing is excellent for individuals who lack the time to find their own investments, or lack experience in the stock market. Such investors can turn to index funds, where they can park their money and realize long-term growth as the economy prospers. The everyday American, with no knowledge of the stock market, can contribute a portion of their paycheck to their investment portfolio in index funds, and could have the potential to retire many years earlier than if they hadn’t invested.
Index funds are safe to invest in, as they are highly diversified to resemble market indexes, and nearly always get returns that match overall market returns within a small deviation. Index funds are low-cost too. Often, there is only a small fee. For the SPY index fund, the gross expense ratio is a mere 0.0945%. As long as you buy a fund from a trusted managing company, such as State Street SPDR or Vanguard, your money will be safe and reflect broader market returns. There is low-cost, low-risk, and good returns. The prospect of making 10% a year without doing any active management is exciting and one that anyone should consider.
What alternatives are there?
The drawback to passive investing is that there is not the potential for short-term profitability. A fund manager is usually required to minimize risk and match a market-basket of stocks to an index, while keeping buying and selling at a minimum to prevent large costs. Instead, one can choose to invest in hedge funds, though this is difficult according to Sean Ross from Investopedia as it requires the investor to be “accredited,” meaning they have “a net worth of more than $1 million and a sophisticated understanding of personal finance, investing and trading.” Hedge funds are typically Long/Short, meaning they can profit in both bull and bear markets.
One could also choose to be an independent “active investor.” Such investors don’t believe in this efficient markets theory, instead choosing to believe that there are small amounts of arbitrage in stock prices that can be profitable. Thus, one could attempt to make many trades a day, in order to generate small profits on each trade in the short-term.
The alternative that I would recommend, assuming someone has a baseline knowledge of investing, would be to follow the financial markets for a few hours a week. A few hours of research have the potential to yield excellent value stocks, or stocks of companies that have good management teams and sustainable future plans. These stocks have been beaten down into oversold range, but they are set to recover. They also tend to pay nice dividends of more than two percent. If you have the time and knowledge to assemble a minimally-managed portfolio of 10-20 stocks, there is potential to beat the market and grow even more wealth. Warren Buffett’s “Buy and Hold” strategy is one that truly pays dividends in the long-run.
Lacking time or energy to research and find stocks to purchase is one justification for not investing, but this can be easily fixed. Investing in index funds through a passive strategy can yield great returns, and also ensures that you don’t lose out on economic growth in the long-run. By effectively contributing a portion of your monthly paycheck to index funds, you can expect to see great returns in the long-term. Index funds are an excellent place to park your money, as they are cheap, low-maintenance, and yield returns that nearly always match the broader market.