Now, if you’ve searched the internet for investing videos or stock picking videos, I’m sure you have at one point come across a video of some dude trying to sell you his master course on stock picking. Well, here I am today also to sell you my masterclass. Oh, wait, no, sorry, that is a joke.
Instead, today I will discuss some of the reasons why passive investing can be a much better option than being an active investor. Because let’s face it, the idea of finding a small-cap stock that will grant us 200%+ returns over the next couple of weeks is ideal. Yet, it’s very unrealistic for many of us, simply because we are not trained to do it, among other reasons.
Therefore, those who might fall under this category might find it ideal to choose a very passive investing approach. As well as those who want to invest but don’t want to do it very actively.
Below I will highlight and explain these reasons as well a brief definition of passive investing itself. If you appreciate content like this or can think of other explanations/benefits, please let your comments below in the comment section of this page.
What is Passive Investing?
You may have heard the term “passive investing” before, but to either serve as a reminder or inform you now, passive investing is a form of investing which requires little time to do.
Typically, when I hear of passive investing, I think of investing in ETFs or mutual funds, securities that require just to be purchased, while someone or something else does the work. I would consider investing with a financial advisor a form of passive investing. This is because they are doing the work of investing in securities for you based on your needs and risk tolerance.
Other forms of passive investing could be businesses or giving out loans. It’s an investment that requires you to perform little work, relying on the aid of someone or something else. Similar to passive income in this sense. But that’s another topic for another day.
You’re just putting your money into someone or something and letting them do the work so you can relax or focus on other essential areas of your life.
So now that we have a basic understanding or reminder of the definition of passive investing let’s look at its benefits/reasons as to why it’s better than being an active investor.
By now, I’m sure a few of us have read The Intelligent Investor, which was written in the ’40s or ’70s by Benjamin Graham (it depends which version you would have read). While this book does provide great detail and advice on how to invest correctly, it does not guarantee the success of anyone who reads such a book.
Stock selection can be challenging because while you can measure specific ratios and formulas to measure a company’s fair value and health, at the end of the day, you are required to provide your judgment amongst the company.
This judgment may come to whether management is suited well to continue its operations with the company, whether it is taking the proper steps to have a solidified future with adequate returns, among other factors.
Many have tried to purchase what seemed to be good companies or companies that, on the surface, look to be companies with massive potential for excessive returns. But I won’t be the first person to tell you that they have failed.
Even other factors like FOMO (fear of missing out) have cost the returns and money of investors because they showed up too late to the party of what was delightful returns.
Now, don’t let my writing take you away from trying to select your stocks. Whether or not you decide to try, it is your personal choice. Just ensure you have done plenty of research, developed a great mindset, and be optimistic but expect there to be rough times ahead.
But with passive investing, you don’t need to worry about these things. Instead, you can invest in such investments that track a particular index that follow the market. Something that will be discussed below under a different section.
Instead, you are required to pick a few funds or ETFs per se, throw some money into it, and let it sit for some time while you hope that your overall return will do very well for you. Maybe better than the stocks you would have picked if you decided to go a more active route.
Do you know what could end up coming with active investing? The stress of needing to achieve certain returns, the pressure of ensuring the company appears as it seems, and the tension to build a portfolio of at least 10-30 stocks.
Imagine trying to find 10-30 individual stocks, but you can’t even find one. Stressful. Well, I can imagine how stressful and frustrating that would be. You have to consider the amount of time that would need to be put into this type of strategy.
It may not be much of a worry if you’re very passionate about investing and love the idea of seeking that one stock that is too good not to put into your portfolio. If that’s you, then you’ll likely skip over this section altogether, which I don’t blame you for doing.
But if you are new to investing, know that it isn’t all sunshine and smiles. Trying to be diversified while also including stocks that pay decent dividends is criteria not everyone meets. There may only be very few companies that meet a specific set of standards, and it is required by the investor to seek these out and analyze them.
With the technology that we are presented with today, this may not be as much of a trouble. You can screen stocks listed on an exchange by different filters, which admittedly does help reduce the stress of finding those few extra stocks for the portfolio.
Then again, it is much simpler to purchase some index funds that track a particular market. If you buy a fund that tracks an index such as the Russell 3000 index, your fund is going to target to provide the returns of the 3,000 largest traded companies on the U.S. stock exchange as a whole! Take that minor portfolio!
Indeed by now, you see how one would have their stress reduced. Every month, an individual may throw a bit of money into this index and a couple of others, which may take 20 minutes to do, then decide what else they want to do for the day.
Onto the following reason:
Track the Market
Another massive benefit of passive investing is that you’re able to track the market. What does that mean? Well, funds and ETFs aim to track the returns of a particular index if they decide to dedicate them towards one specific index. However, note that it doesn’t always happen. The fund or ETF could do much better or a little worse. Generally, the returns compare to the index are very similar.
Imagine instead if you were to try to pick your stocks in a portfolio. Do you think you would do better than the S&P 500 over the long term? Take this fact into consideration:
“According to new data from S&P Dow Jones Indices, 60.3% of large-cap equity fund managers under-performed the S&P 500 (^GSPC) in 2020” (source: Yahoo Finance).
And these are professionals. But don’t let this fact hinder your decision to be an active investor. It, in particular, can be exhilarating and very worthwhile. Look at famous investors like Warren Buffet and Charlie Munger. However, what is wrong with tracking the market as a whole?
“The S&P 500 Index originally began in 1926 as the “composite index” comprised of only 90 stocks.1 According to historical records, the average annual return since its inception in 1926 through 2018 is approximately 10%–11%” (source: Investopedia).
A 10% through passive investing? Now that isn’t such a bad deal. This fact alone had been a significant decision for those to switch to passive investing and save time. Which speaking of:
I’ve eluded to time a couple of times previously, but imagine all the time you would save by being a passive investor. There would be no need to search through hundreds or thousands of stocks, analyze each one, and evaluate whether they should be added to the portfolio. That is a handful in itself.
I think that time should be the sole decision for your investing style. If you are willing to put in the time to be an active investor, then great, go ahead. Otherwise, if you want to throw some money into an advisor or particular security and let them do the work, that’s also great.
There isn’t even a lot much more to say on this benefit. I think it’s pretty apparent that you would save a significant amount of time through passive investing, and I suggest you do too. So let’s move on.
It Can Be Cheaper
Let’s look at the Russell 3,000 index again. It’s a fund that holds the 3,000 largest trading companies on U.S. exchanges. But how much would it cost you in total to purchase one share of each company? While I don’t know the exact answer, I do know that it would cost a lot.
And let’s say you could purchase one share of each company. What would the returns be? Well, it would be very similar to the return of the index itself theoretically.
So now, imagine purchasing an ETF that follows this particular index with relatively the same return but only costs $250 per fund. Well, that’s a hell of a lot cheaper than purchasing one of every stock.
Why yes, it is. Having a passive investing strategy like this could end up saving someone much money, not just time. You will have to pay a bit of money to purchase a particular ETF that follows an ETF probably, and you most certainly will have to spend much money to buy an index fund.
Yet, both options are much cheaper compared to buying each stock of a company in an index. So I understand where this may be a disadvantage to passive investing, that it still can be expensive than active investing.
I can’t deny that. So you may pay a little more than a stock of a company, but you must take into consideration the other advantages of holding this ETF or index fund. I would think that the benefits outweigh the disadvantages.
But what if I don’t earn as much as I would have with active investing?
Maybe, after all, you were meant to be an active investor. You could have earned over 20% more of a return compared to the stock market as a whole. There’s always that potential with active investing that you will do much better than the entire market will.
Yet again, how much time did you spend on active investing, and was it worth it to spend that much time?
To me, the first question you need to ask yourself when investing is whether or not you want to spend much time at it. The answer can pretty much indicate which investment style you’re going to go towards, which by now, you probably understand.
Either way, being an active or passive investor still brings about significant risk, and you can tailor your risk tolerance to the amount of reward you want to seek potentially. There are funds and ETFs that are designated to be high risk, high reward.
Yet, it’s much easier for you to throw money into one of these securities and go on and live your life or focus on your other priorities than to spend enormous amounts of time a year just analyzing stocks to hold or to avoid.
At least, that’s how I see things anyway. The choice will always be up to you at the end of each day.
So, I hope that you choose very wisely.
Personally, I will be choosing to have a passive approach to investing. This is something that I have mentioned before and will plan to discuss the securities I will be purchasing.
I hope this article helps influence your understanding of passive investing and furthers your journey to searching for your own investment style.