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Passive investing: what is it and how does it work?

A passive investing strategy aims to grow your wealth, fulfill your long-term financial goals, and combat costly investing mistakes. 

Passive investing using so-called index funds began in the US more than 40 years ago. The approach spread to the rest of the world, including the UK. 

The strategy is endorsed by Nobel Prize winners and investing greats like Warren Buffett. It even gets the nod from the UK’s financial industry regulator, the FCA.

No wonder. A passive investing strategy offers you the surest path to long-term investment success. And it’s easily implemented by a DIY investor.

Once you understand how passive investing works, you’ll be equipped to set up and manage your own investments with minimal impact on your time.

Our mission is to explain what you need to know.

What is passive investing?

Passive investing is so named because it advocates broad market diversification and minimal trading at a very low-cost

This passive approach contrasts with an ‘active investing’ strategy.

Active investors try do do better than the market by making narrower bets, generating higher trading turnover as they do so. Trading increases costs like coal-fired power stations belch CO2. 

And cost is the key reason why passive investing beats active investing over the long-term. We’ll come back to the importance of costs shortly. 

Passive investing strategies are executed using passive funds.

What are passive funds?

This class of investing vehicles are collectively called index trackers. Index trackers sub-divide into ETFs and index funds. 

You can learn all about the pros and cons of ETFs vs index funds

But the important thing is that both passive fund types offer easy access to the set of mutually reinforcing asset classes that should form the building blocks of your passive portfolio

Your chosen asset classes should do one or more of the following jobs:

  • Increase your returns
  • Lower your risk
  • Protect your wealth in a wide-range of economic conditions
  • Maintain liquidity (you can readily sell assets for cash when needed)

The best passive funds offer you a diversified slug of a useful asset class at an extremely competitive cost. 

Once you understand how the key asset classes complement each other, you can mix your own blend to meet your goals using low-cost index funds and ETFs. 

Passive vs active investing 

Active investing strategies promise to help you beat the market. 

Passive investing strategies don’t. They offer the certainty of achieving close to average market returns. 

It’s easy to promote active investing as the path to riches for eager people who want to believe they’re above-average. 

Passive investing, by contrast, sounds defeatist. You’re admitting from the outset that average is the best you can do. Who wants to be average? 

But the fact is that active investors as a group cannot fulfill their ambition to beat the market. It’s mathematically impossible because active investing is a zero sum game

Here’s a short explanation.

The market is made up of passive investors and active investors. Passive funds simply follow the market and capture its average return. This leaves active investors, who take positions depending on their views and strategies.

One active fund may sell its Amazon shares to another investor who is more optimistic about Amazon’s future.

For every trade, there’s a buyer and a seller. A particular active fund might do well from its bets. But across all active participants, the winners are cancelled out by the losers.

Hence the money invested by all active investors only earns average market returns, minus costs.

The set of all passive investors also earns average market returns, again after costs. That’s what passive funds are designed to do, and they’re very good at it. 

But passive costs are lower.

The result is that passive investors beat active investors as a group.  

This is why Warren Buffett loves index funds

Warren Buffett, because he’s a genius, sums up the equation in two sentences:

If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win.

Hence Buffett advises the general public to use index trackers:

Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. 

A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.

Buffett doesn’t think you should pick stocks yourself, either:

Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.

Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

Do you really know better then the world’s greatest investor?

Why you shouldn’t play the active game

If you’re sure you’ll finish in the active investors’ winners’ enclosure over your investing lifetime then you should take the active route. 

But you can’t be sure. In fact the evidence shows the effort will probably cost you a great deal of wealth. 

That’s because ordinary folk are hopelessly outclassed by huge, smart-money firms that dominate the active investing arena. They are the winners who will likely relegate you to the losers’ end of the league table. 

The typical response from people determined to roll the dice is two-fold:

  • Hire an active fund manager who will place their market-beating skills at your disposal. 

  • Rely on their own investing edge to beat the market. Perhaps they believe they possess above average intelligence. Maybe they think they can better see that the future will belong to tech firms and big pharma. 

But these strategies typically fail over the long-term because:

  • Most active fund managers can’t beat the market for long. This is shown every year by the much-respected SPIVA review. As for the few winners, it’s extremely difficult to identify them in advance says the FCA.  

  • Most people do not have any investing edge. Or they can’t maintain it consistently over time.

Intelligence alone is certainly not enough.

The investment industry attracts the best-of-the-best and backs them with billions of dollars in computing power, AI-buddies, and logistical support. They’re silently playing you at 3D Chess while you’re playing checkers. 

Buying into the investing sectors, themes and megatrends of the future is another obvious move that, counterintuitively, is a classic blunder. 

Still sceptical? Then please review the evidence. We’ve accumulated the key points in a deeper passive vs active investing review. 

Again Warren Buffett sums it up:

By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.

Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.

Buffett doesn’t need your money and he doesn’t fear your competition. He is simply offering his best advice for free. 

Also read this second opinion from an ex-hedge fund manager turned passive investing evangelist. 

Inside passive funds

Your passive funds won’t outperform the market either – but nobody claims they will.

Rather, such funds own the entire market, as defined by their index. (That’s why they’re called index trackers.) 

If you want to hold global equities, you simply buy a global tracker fund that follows an appropriate index. For example the FTSE All-World index, which represents the global stock market.

You can also own passive funds that deliver the return of the bond market, commodities like gold, or any other slice of global capitalism you can imagine. 

Behind-the-scenes, you’re pooling your money with other investors to buy into thousands of companies (or bonds, or bars of gold). 

This form of collective investing enables a passive fund to, for instance, cheaply purchase the shares of nearly every major company listed on a particular stock market.

Or even every important stock market in the world!

Such diversity is vital. It means you aren’t relying on the fragile fortunes of just a few companies. Instead you’re buying into the prospects of entire industries, countries, and continents.

Because the best passive funds own their particular market as efficiently as possible, they ensure you consistently pick up the average return, minus some extremely low costs. By creaming off capitalism’s bounty, you’ll outperform investors who pay higher fees for lower returns. 

If you have no real reason to believe you know something that other investors don’t, then invest in passive funds and take the market return.

Passive investment strategies

Okay, deep breath. This is how to do passive investing. 

You start with your financial goals. Perhaps you’d like to retire early (or at all), send the kids to uni, or buy a secret volcano base.

Knowing the what, when, and why enables you to estimate the four critical parts of your passive investment strategy:

  • How much money you need
  • How long you need to invest
  • How much money you need to put in
  • How much risk you need to take

Here’s how to put those elements together to create a plan for financial independence

A follow-up piece will help you answer the question how much do I need to retire?

You can also click through for guidance on how much should I put in my pension?

Construct your passive portfolio

With your plan in place, you pick a portfolio of passive funds to deliver on your goals. 

The most important decision you’ll make is your asset allocation. In particular your split between equities and bonds:  

  • You invest in faster-growth equities to power you towards your goal…  
  • …but you also put enough in safety-first bonds to stay calm when equities tumble. 

The financial advice industry uses metrics such as risk tolerance to help people understand how much risk they can take. (Risk here is mostly shorthand for owning more volatile equities.)

Choose a passive portfolio that aligns with your risk tolerance. Even seasoned investors can find stock market crashes hard to handle.

Here are some model portfolio ideas to help you build your own asset allocation. 

This is another take on model portfolios using ETFs. 

Remember there’s no right answer. Asset allocation is as much art as science. 

Risk vs reward

No matter whether you choose a passive investing strategy or not, all investing entails risk

Sadly that’s as inevitable as the chance you could be in a traffic accident every time you get into a car. 

If anyone offers you a ‘safe’ investment, they’re taking you for a ride. There’s no such thing. The risk vs reward tradeoff explains why. 

Though past fund performance is not relevant, historic asset class returns give you a sense of what’s possible.

You can expect a highly-diversified portfolio of equities to outperform bonds and bonds to outperform cash over the long term. If it were otherwise then investors wouldn’t need to invest in riskier assets.

Equity returns are your reward for taking the risk that in some years – even some decades in extreme cases – equities underperform bonds and cash.

This is the dark side to the higher returns you hope to get from equities. You’ll experience volatile returns and the occasional prolonged downturn.

Prepare yourself by learning what to expect during those bear markets, and how to handle them.  

Diversification

You can’t rely on any single asset class or investment to perform like clockwork. Portfolio diversification is our best response to that harsh reality. 

Most people find this concept easy to grasp when it comes to diversifying equities. We’re used to hearing about adapt-or-die competition between companies. 

The role of bonds is much less intuitive. So read up on the defensive side of your asset allocation. 

Runaway inflation is a particularly tricky threat, as it can maul equities and bonds simultaneously. There’s no perfect solution. Consider your inflation hedge options in advance. 

Finally, we can’t expect assets to always deliver on demand. Please check out this piece on protecting your portfolio in a crisis. 

How to buy your passive funds 

You buy, trade, and hold your passive funds through an online brokerage account.

A broker is no more than an investment supermarket. And just like any supermarket it’ll be chock full of products. They’ll range from the healthy and sensible to naughty sugar-bomb highs that are fun for a while but will damage your wealth. 

Your broker’s index tracker offerings are like the veg aisle. Nourishing and wholesome. But your eye will also be drawn to more colourful fare. Winking at you like the tasty treats at checkout queues.  

Hot shares, spicy funds, saucy options, and lashings of CFDs. The worst containing the nutritional value of gummy bears made from boiled skin and pig cartilage. 

Avoid this addictive, tooth-rot crack and stick to your investing broccoli. The following diet is boring but it works:

Maximise your returns by using your legitimate tax shelters to protect every pound that you can. See our lowdown on ISAs vs SIPPs

Find out how to optimise your ISA and SIPPs if you’re on the path to financial independence. 

Broker’s fees should be hammered down like any other cost of investing

Monevator’s broker comparison table will help you keep your cash in your pocket. 

Many first-timers get nervous about making a mistake at this point. Read our walk through opening a broker’s account.

And please don’t worry. It’s a little more complicated than an online bank account but you’ll soon learn the ropes. 

Managing your passive investments 

Once you’ve got the passive investing ball rolling you can afford to be hands-off.

In fact, constantly tinkering with your investments typically does more harm than good.

Investing legend Benjamin Graham skewered the secret saboteur within us all, warning:

The investor’s chief problem — and even his worst enemy — is likely to be himself.

The best course is to leave your portfolio alone. Let your assets rise like buns in the oven.

Because we choose regulated assets with a long track record of good returns, your money should grow over time. Eventually your wealth is large enough to support your goals.

The sooner you start, the less money you’ll need to throw at your objectives later. Exploit the snowball effect of compound interest. Use our compound interest calculator to see what can be achieved. 

In the meantime:

Shortcuts to a passive portfolio

We’ve thrown a lot at you. A book’s worth of content at least! Some people substitute rules of thumb in place of a proper plan. At least it gets you started.

If it’s all too much then know the industry default position is a 60/40 portfolio. That comprises a portfolio of 60% equities and 40% high-quality bonds. 

The simplest way to own such a passive portfolio is with a multi-asset fund such as Vanguard LifeStrategy

Alternatively, check out our round-up of the best multi-asset funds

Target date funds are ideal if your goal is retirement and you want a near fire-and-forget portfolio. 

The benefits of passive investing

Passive investing is a great choice for most people because it is:

  • Easy to understand
  • Transparent
  • Low cost
  • Low maintenance
  • Based on sound investing theory and practice
  • Relies on the productive capacity of the global economy
  • Does not depend on predicting capitalism’s winners and losers

Passive investing UK

I’ve personally used a passive investing strategy to become financially independent. Passive investing works in the UK.

Many of our readers, too, are investing in index trackers to achieve their aims.

Monevator is primarily about passing on that experience to other DIY investors to help them reach their financial goals. 

You’ll find our latest new passive investing articles below. Subscribe to get them free via email!

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