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Passive investing: Is it right for you?

Many investors are weighing the potential advantages over active investing.

By Clay Ernst, Executive Director, Financial Planning

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Last updated: November 17, 2022 |

Article published: November 17, 2022

Fifty years ago, investing meant actively buying and holding stocks. But in 1976, then-CEO of The Vanguard Group John C. Bogle pioneered the index fund, allowing individual investors to buy shares in a fund that mirrored the S&P 500. This revolutionized investing by making it more accessible to the everyday investor.

Active vs passive investing

In active investing, you buy and sell individual stocks – either directly or through a fund manager – attempting to time and beat the market. You must be willing to put the time and work into researching companies, handpicking stocks, and actively managing each asset in your portfolio.

In passive investing, you invest in a mutual fund that includes a range of assets to mirror what the stock market is doing. Index funds and exchange traded funds, give you the option to invest across industries and interests, helping you to diversify your portfolio. With this passive approach, you invest fully in a fund for the long term rather than making frequent transactions as you would with active investing.

Pros and cons of passive investing

If you’re trying to decide if passive investing is best for you, you may want to consider the following pros and cons:

Potential benefits:

  • Lower fees. You’re not actively buying and selling stocks, so with fewer transactions, passive investing may cost you less.
  • Less maintenance. You don’t need to spend time tracking individual stocks or attempting to predict the market.
  • Returns over the long-term. Data over the past decade shows that passive funds may outperform active vehicles over time. S&P Indices versus Active data revealed more than 90% of Large-Cap actively managed funds underperformed the S&P 500 over a ten-year period.
  • Tax efficiency. If you’re holding assets over the long term, rather than buying and selling stocks frequently, you could pay less in capital gains taxes. The trading volume in a passive fund can also be lower compared to active vehicles, which may trigger fewer fees and less tax consequences.

Potential drawbacks:

  • Limited choice. When you invest in an index or ETF, you’re choosing the entire fund. You don’t have the option of handpicking stocks or deselecting an individual stock in the fund.
  • Unpredictable returns. Not all passive funds are created equal, and since they seek to mirror the market, it’s possible your investment may not gain above-market returns.

All that said, historically speaking – though past performance is not a guarantee of future returns – stocks have risen on average 7 out of every 10 years, according to data from Dimensional Fund Advisor. So, you can see that staying invested over the long term may provide a more favorable return.

Passive investing strategies for the long haul

Years of performance data shows that no one has ever demonstrated an ability to buy and sell at the right times consistently over any meaningful length of time, including professional asset managers. You’re likely better off maintaining a long-term focus. Take this example as evidence of the risk you take by not investing in every asset class and market sector:

  • hypothetically, if you invested in all 16 major asset classes and market sectors from 2007–2021, the portfolio would have earned 7.8% per year.
  • If you missed the three best market sectors each year, you would have earned 3.9% per year.

There are many major asset classes and market sectors, and in any given year, some will outperform others … but there is no pattern and past performance doesn’t guarantee future results. So, it’s best to own a portfolio designed for your risk tolerance and goals and is as diversified as possible – fully invested in the major asset classes and market sectors – and to stay invested all of the time.

ESG a growing trend

Committing to passive investing doesn’t mean forgoing your interests. Almost 90% of ETF investors globally plan to add environmental, social, and governance exposure to their portfolios, according to the results of a January 2022 survey by Brown Brothers Harriman. And to meet that demand, thus far in 2022, ESG-focused ETF launches have doubled since last year, according to data compiled by Bloomberg.

The growth of ESG funds isn’t new, but the pace appears to be escalating. Some might think an ESG focus is counterintuitive to a passive investment approach, but once the funds are chosen, management can remain passive. And going the ETF route keeps even your more targeted investment mix diverse.

The bottom line on passive investing

With potentially lower fees, less maintenance and tax efficiency, there’s no wondering why passive investing has become so popular. If you want to learn more about how passive investing can help you meet your financial goals, connect with a planner today.

 

Investing strategies, such as asset allocation, diversification or rebalancing, do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. All investments have inherent risks, including loss of principal. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Past performance does not guarantee future results.

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