Passive investing

What is passive investing?

Passive investing uses market-weighted indexes and portfolios to invest funds and avoid many of the fees common to more active investment strategies. Passive investing minimizes buying and selling, which allows investors to avoid drags on performance that commonly occur with frequent trading. Passive investing differs from more active strategies in that wealth builds slowly over time.

Deeper definition

Passive investment emerged in 1975 with the creation of the first index fund by John C. Bogle, who was The Vanguard Group’s CEO at the time. The fund allowed retail investors with the company to invest in the Vanguard 500 exchange-traded fund (ETF) with minimal effort and cost.

The number of ETFs grew in the ensuing years. Today, investors can choose from a wide selection of ETF accounts. Some active investors outperform the various indexes in a particular year, but index funds, for the most part, tend to outperform most active managers, especially in the United States.

Passive investing also helps investors avoid some of the pitfalls of actively selling and buying on the stock exchange. Unprepared active investors might panic and sell stock when the market loses ground, losing money as the stock market rebounds and stock prices go back up. Passive investment helps prevent this because the investment is in an index, not an individual stock.

Passive investment strategies have grown in popularity. With performance levels on par with active investments, passive investors usually see savings that more than make up for riskier investments. In addition, passive investment accounts tend to offer a safer alternative to actively playing the market, albeit at a slower rate of growth.

Passive investment example

Passive investment is intended to make investing easier by using an index fund to track specific individual investments contained within the fund. Passive investments comprise either a mutual fund or ETF, such as the SPDR S&P 500 ETF, VanEck Vectors Gold Miners ETF, or the United States Oil Fund.

Passive investment includes multiple strategies, with the most common being the investment of pension funds in a mutual fund or ETF. Mutual funds and ETFs similarly hold portfolios of stocks, bonds, precious metals, or other commodities. Beyond this, mutual funds and ETFs differ significantly.

Mutual funds differ from ETFs in that they trade at the end of the day. In addition, companies specifically manage investments within the mutual fund through a brokerage firm or directly. Mutual funds also assess a penalty if you sell shares too early, sometimes up to 1 percent of the share’s value.

ETFs, on the other hand, trade on an exchange. Investors can buy or sell at any point during the trading session for that particular day. In addition, when trading with an ETF, minimum holding periods don’t apply. ETFs offer a more cost-effective route to investing, as they don’t charge many of the fees associated with a mutual fund.

Use our calculator to see whether you’re on track to meet your investment goal.

Other InvestingTerms

More From Bankrate