I love passive investing. I always have been and always will be. Why? Because I hate diving through financial statements and worrying over yields and price-to-earnings ratios. I’d rather be outside enjoying life than inside looking at all kinds of different numbers and losing money day-trading (that’s what most of them do).
When it comes to investing, there are two main approaches: passive and active investing.
Passive investors buy and hold a diversified portfolio of investments for the long term, while active investors try to beat the market by buying and selling stocks more frequently.
While active investing may seem more exciting, research has shown that passive investing tends to produce better results over the long run (even though so many active investors incorrectly believe they can beat the market).
Here are some reasons why.
Lower Costs
One of the biggest advantages of passive investing is lower costs.
Active investors often pay high fees for portfolio managers, research, and trading commissions. These costs eat into investment returns and can significantly impact long-term performance.
In contrast, passive investors typically invest in index funds or exchange-traded funds (ETFs), which track a market index and have lower fees. With less money going towards fees, passive investors have more money to compound over time.
Diversification
Another advantage of passive investing is diversification.
Passive investors typically hold a mix of stocks and bonds, spread across multiple industries and regions. This diversification helps to reduce risk by spreading it across a broad range of investments.
In contrast, active investors often take concentrated positions in a few stocks, industries, or regions. While this approach may occasionally lead to higher returns if those positions perform well, it also exposes the investor to higher risk if those positions do not perform well (this usually happens).
Consistent Performance
Passive investing also tends to produce more consistent performance over time.
Active investing relies on a portfolio manager’s ability to pick winning stocks and time the market. However, research has shown that very few portfolio managers are able to consistently outperform the market over the long term.
In contrast, passive investors don’t try to beat the market – they simply aim to match its performance. By holding a diversified portfolio of low-cost index funds, passive investors can capture the long-term growth of the market and avoid the volatility of individual stocks.
Emotional Discipline
Passive investing also encourages emotional discipline.
Active investors often get caught up in market fluctuations and may make impulsive decisions based on fear or greed. For example, they may sell stocks during a market downturn for fear of further losses, only to miss out on the subsequent rebound.
In contrast, passive investors tend to have a long-term perspective and don’t get swayed by short-term market movements. By sticking to a well-diversified portfolio and avoiding emotional decisions, passive investors are more likely to achieve their long-term financial goals.
Tax Efficiency
Finally, passive investing tends to be more tax-efficient.
Active investors frequently buy and sell stocks, which can trigger capital gains taxes.
In contrast, passive investors typically hold their investments for the long term, which can reduce the amount of taxes owed. Additionally, passive investors can use tax-efficient investment vehicles, such as index funds, which are designed to minimize taxes.
In conclusion, passive investing has several advantages over active investing.
It tends to have lower costs, better diversification, more consistent performance, encourages emotional discipline and is often more tax-efficient.
While active investing may seem more exciting, research has shown time and time again that passive investing produces better long-term results.
By holding a diversified portfolio of low-cost index funds and avoiding emotional decisions, passive investors can build wealth over time and achieve their financial goals.
