What is passive investing?
Usually, you don’t describe something as passive to be complimentary. We have a tendency to prefer action to inaction, and the idea of just sitting back and letting things happen runs a little contrary to our national brand.
But is being a passive investor a good thing? Maybe*. First though, a brief description of what it means:
Passive investing rests on the principle that owning a broad range of stocks and bonds, then not making a lot of frequent changes to the portfolio, is preferable to making short-term changes. Certainly it’s less expensive for the investor. This is most commonly achieved by using indexes like the S&P 500 (this represents large US companies, the ones you surely know), the Russell 2000 (this comprises small US companies), and the MSCI EAFE (non-US and Canada companies). You can buy mutual funds or ETFs that try to mirror, or track, these benchmarks, or others, as closely and inexpensively as possible. These funds make it easy to buy everything you want, all at once.
A well-designed portfolio will have a mix of the above and other indexes, resulting in exposure to everything, in proportions that are aligned with your needs and goals, and what kind of investor you are.
Each portion of your portfolio will behave differently. You can reasonably expect a small company index, or one that invests in the companies of emerging economies globally - both important drivers of long-term growth - to be more volatile than a large US conglomerate that’s been around for a century. So periodically, a portfolio needs to be rebalanced to keep things in the right proportion.
But simply owning index funds, or index ETFs, is not enough to make a passive strategy - indeed, if you frequently buy and sell these, it’s not functionally much different from owning individual stocks. What happens after you establish your portfolio and set parameters for how to keep the portfolio in balance is what sets the stage for the benefits of a passive strategy to come to fruition.
It’s important to leave it alone and get out of the way! And this can be a lot harder than it seems, especially when markets are being particularly theatrical. Other than investing new money as you add more, rebalancing should occur infrequently, even just once or twice a year. Periodically, investments should be reviewed to ensure they’re still the best way to implement the strategy, but not in an attempt to chase return or time the market. If you find yourself frequently second-guessing whether an investment is right for you, or being tempted to include an investment idea that doesn’t quite fit with the rest of the strategy, consider establishing a separate account, not tied to your broader plan, to explore these ideas. It can be very informative and instructive to experience the market in this way, and that allows the main portion of your investments to remain disciplined.
It’s also important to understand that while passive investing attempts to remove as many behavioral and emotional biases as possible, it’s not meant to be dogmatic and rigid. New concepts emerge all the time, and if they make sense in the context of the diversification ideal, there’s room for them in a passive portfolio. I fully expect cryptocurrencies to take their place in the coming years, for example, as the expectations around them coalesce. Similarly, how we invest in general will change - the dawning of the age of direct indexing, in which an individual investor will have the tools to easily construct their own index out of any parameters they like, will soon be upon us, and that will have a profound impact on how we think about our investments. How we measure return will change too, as we shift away from simply thinking about growth and dividends, to think too about the measurable impact our investments have on the environment, for example.
Just like any investment strategy, having a clear vision and sense of your goals, and a sense of yourself as an investor, is key.
*yes