Passive investing is an investment strategy that aims to maximise returns for investors by minimising costs incurred through buying and selling. Broadly speaking, passive investing is a ‘buy-and-hold’ investment strategy, aiming to generate long term returns rather than short term results. A common form of passive investing is ‘index investing’, whereby investors purchase a representative benchmark of a specific index, such as the S&P 500 or FTSE UK All Share.
Unlike active investors, passive investors do not seek to profit from stock selection, short term market changes or fluctuations through market timing, instead the goal is to build wealth gradually, with the underlying assumption that markets post positive returns over time.
It is generally agreed that it is difficult to outperform the market consistently through active stock picking. Evidence suggests only around 1% of active fund managers achieve this successfully in the long run*. Passive investing instead aims to construct well-diversified portfolios, with the goal of matching market or sector performance.
By creating a suitably well diversified portfolio, risk is spread broadly across all holdings within a passive portfolio, meaning short-term market fluctuations bear little relevance on overall performance over time. By tracking a target index or benchmark, passive investments avoid the need for constant buying and selling of securities, leading to lower transaction and management fees than commonly found with actively managed funds. Of course, passive investments are not immune from risk. As the investment tracks the entire market or market sector, should that market value decline, then so will the value of the fund itself. Historically, these declines are usually short lived, and research conducted by Charles Schwab in 2012 found that, over any 20 year period (between 1926-2011) a passive holding never produced a negative result.
*Blake, D., Caulfield, T., Ioannidis, C., & Tonks, I. (2017). New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods. Journal of Financial and Quantitative Analysis, 52(3), 1279-1299. doi:10.1017/S0022109017000229