Passive Investing: 6 Advantages to the Hands-Off Approach

When it comes to managing investments, there are two main philosophies: active investing and passive investing. You may be thinking, “Why opt for a passive investment strategy? Wouldn’t I want to stay actively involved and ‘on top’ of my investments?!” Of course you do. But it doesn’t have to be done through a time-consuming, costly and tax-inefficient strategy (Hint: these are common qualities of active management). 

Below, we’ll outline the concepts of active and passive management as well as 6 reasons why adopting a passive investment philosophy would be the preferred choice. 

A Closer Look at Active and Passive Investment Philosophies 

There are fundamentally two styles of investing: active management and passive management. 

What is active investing?

Active management is a hands-on investing approach consisting of investors who are looking to beat a specific market index (or benchmark) through targeted investing, timing the market, and any number of strategies that seek higher than average returns. 

As an active investor, you may have a lot of individual common stocks or actively managed mutual funds or active Exchange-Traded Funds (although to a lesser extent) within your investment portfolio. Actively managed funds are funds with portfolio managers that select investments that seek to outperform a benchmark. You may also utilize more alternative investments, like private equity and hedge funds. 

Through active management, investors have a strong belief that skillful portfolio managers can outperform the market by leveraging price movements, market conditions and events (more on how that plays out later!).

What is passive investing?

While an active management approach is looking to outperform a specific segment of the market, a passive management philosophy consists of investors who are just trying to capture the returns of the market while keeping investment costs low.

The investment portfolio of a passive investor may consist of index funds and/or passively managed ETFs. 

A passive investor isn’t concerned as much about capitalizing on short-term market movements or particular market events (i.e. market timing) and instead believes in the long-term potential of an investment over an extended period (i.e. a buy and hold strategy). This is reflected by replicating the investment results of a target index by holding all or a representative sample of the securities in the index. 

A passive investment strategy operates under the assumption that market efficiency over the long term will produce optimal results. 

6 Key Reasons for Adopting a Passive Investment Approach

If you’re an avid user of the NewRetirement Planner, you very well may be a DIY investor who fully understands the benefits of a passive investment strategy. 

However, if you’re still undecided about your beliefs on investing or looking for more insights, below are 5 reasons why many investors are opting for a passive approach over active management. 

1. Passive investments cost less 

As the names imply, an active investor is attempting to beat the stock market whereas a passive investor believes markets are efficient and is trying to capture the returns of a specific sector of the market. Passive funds don’t have human managers making decisions in order to try to beat the stock market. With no managers to pay, passive funds generally have very low expense ratios. 

Although fees for actively managed funds have decreased over time, index funds and passive ETFs are still the winners here according to the Investment Company Institute 2023 Investment Company Factbook. In 2022:

• The average expense ratio for actively managed equity mutual funds was .66%
• The average expense ratio for index equity mutual funds was .05%
• The average equity ETF expense ratio was .16% 

Although the gap between .66% and .05% may seem insignificant at first glance, it can add up over time.

Let’s take a look at an example: 

• You invested $25,000 in an actively managed equity mutual fund with an expense ratio of .66%
• You also invested $25,000 in an index equity mutual fund with an expense ratio of .05%
• Both funds returned 7% annually for 20 years
• The lower-cost index fund would be worth about $95,842
• The higher-cost actively managed fund would be worth about $85,482, or $10,360 less
• This difference would also compound over time, with the index fund worth about $29,590 more with an additional 10 years of growth 

In regards to investing, it pays to be passive! 

2. You can get better returns 

For many investors who don’t have a strong investment philosophy already, active management may seem like a promising approach. After all, who wouldn’t want to invest in the top-performing funds and steer clear of the under performers?

However, attempts to time the market, select individual stocks, or put together the perfect mix of actively managed mutual funds often fall short of delivering the desired investment results. Most of the professional fund managers who engage in active trading of stocks or bonds are often unsuccessful at generating returns that are better than the index they are trying to beat. 

Since its initial release in 2002, the SPIVA Scorecard has been the go-to scorekeeper of the long-standing active versus passive debate. Below are some stats from the scorecard:

• In 2023, 75% of active U.S. Equity funds underperformed their benchmarks
• In 2023, 68% of active International Equity funds underperformed their benchmarks
• Over a 20 year period, 96.83% of all active U.S. Equity funds underperformed their benchmark (S&P Composite 1500) on a risk-adjusted return basis 

While active managers can indeed outperform the market from time to time, these periods of higher returns are often brief. This makes it challenging not only to identify the top-performing managers but also to find those who consistently outperform over time. Plus, the leading managers can change over time as well. 

3. Passive investing can reduce stress and increase financial confidence

Life can certainly have its stressful moments. Your investment strategy shouldn’t add to that pressure.

Passive investing, with its set-it-and-forget-it approach, offers a profound reduction in stress and an increase in financial confidence for investors. Once you’ve selected a few index funds or ETFs and are comfortable with your asset allocation, most of the hard work is done. With a long-term perspective, minimal intervention and oversight is needed going forward.

By relinquishing the constant need to monitor market fluctuations and make frequent trading decisions, passive investors can enjoy a sense of calm and stability in their investment journey. Rather than being consumed by the anxiety of timing the market or reacting to short-term volatility, passive investors can focus on their long-term financial goals with a clear mind.

By embracing that markets are efficient, you recognize that a long-term, globally diversified, and low-cost passive portfolio offers a more relaxed and zen approach to investing.

4. Want to reduce your tax bill? Stick with passive investing  

Taxes play a role in so many areas of your finances, including your investments. When it comes to investing in taxable accounts, the tax efficiency of a fund can significantly impact the after-tax performance of your investment portfolio. 

Actively managed mutual funds often come with a high turnover rate due to frequent portfolio management decisions. A turnover rate is the percentage of a fund’s holdings that have been replaced in the previous year, leading to taxable capital gains. For instance, a fund with a 100% turnover rate would essentially have an average holding period of less than one year. 

Meanwhile, a passive investment strategy of index mutual funds and ETFs with built-in tax efficiency can minimize the tax drag on your returns. These funds are often more tax-efficient than active funds because they typically have lower turnover rates. An index fund’s buy-and-hold style leads to fewer taxable events and often minimal, if any, capital gains distributions. ETFs may offer an additional tax advantage: The ETF redemption process sometimes allows ETF managers to adjust for market changes without directly selling portfolio securities (saving on capital gains taxes).

As an investor, you should strive to reduce these tax costs and performance drags wherever you can. Utilize the NewRetirement Planner to review your potential federal and state tax burden in all future years and get ideas for minimizing this expense. 

5. A passive approach requires less time

Time is your most precious asset, as it’s limited and irreplaceable. Given its value, it’s important to use it wisely. Investing can be as simple or as complicated as you want it to be. It can save you time or it can take away a lot of your time, depending on your investment strategy. 

Pursuing an active investing philosophy can come with considerable opportunity costs. There can be significant time and effort put into your actively managed portfolio with many questions to ponder such as:

• What is your next move when a portion of your investment portfolio is going through a period of underperformance? 
• If you sell out of certain funds, which funds will you purchase next? 
• If you buy into funds that have done well recently, how do you know they aren’t the next funds to underperform for the next 1, 3, 5 or 10+ years? 
• Or perhaps you plan on staying in cash to “weather the storm”, when do you feel is the best time to get back into the market? 
• If you feel good about certain funds and their portfolio managers, when do you think they will turn it around if they have been underperforming? Or will they ever? 

As you can see, these types of questions can weigh on you not only from a time perspective, but can take an emotional toll as well. Along with this, you also have to do the research on hundreds (if not thousands) of mutual funds and individual common stocks, which is a big time commitment in and of itself. 

Meanwhile, with passive investing, you can essentially pick 1 to 3 index funds or ETFs and set it and forget it, with some rebalancing along the way. One of the few key decisions you have to make as a passive investor is determining the right mix of stocks and bonds (e.g. 60% stocks and 40% bonds) to align with your financial goals and risk tolerance. It’s a lot less time-consuming than the buy-sell, market timing questions and decisions that often come with investing in actively managed mutual funds, private equity, and hedge funds. 

NOTE: Spend less time managing your investments by adopting a passive investment philosophy and focus more on planning your future retirement with the NewRetirement Planner. 

6. You can minimize risk with a globally diversified passive portfolio

Diversification is an essential element of a comprehensive investment strategy. 

Since passive strategies often focus on index funds or ETFs, you’re usually investing in hundreds, if not thousands, of stocks and bonds. This allows for easy diversification and reduces the risk that a single investment performing very poorly will significantly impact your entire investment portfolio. 

Just 2 or 3 index funds or ETFs can provide you with a low-cost, globally diversified portfolio that can meet your retirement savings goals. 

On the other hand, if you’re handling active investing on your own without proper diversification, a few poor stick picks or actively managed funds could erase significant gains in your investment portfolio. Building a globally diversified portfolio through active management can be both time-consuming and expensive, requiring a lot of effort and potentially high fees.

Save Time and Money with Passive Investing and The NewRetirement Planner

While investing is a very important component of building long-term wealth, it isn’t the only consideration. 

Utilize the NewRetirement Planner to build, track, and manage all aspects of your comprehensive financial picture: investments, recurring expenses, medical costs, long-term care, real estate and more. The tool can play a vital role in helping you make informed decisions about your strategies and their impact on your financial security now and in the future.