Unlike active investment, passive investment involves minimal interference in the investment process. This does not mean that it does not exist, but it is minimized. As a rule, passive investing consists of building a portfolio of assets.
Signs of passive investing
Passive investing is long-term: the longer the better. The investor does not take active actions in relation to this asset, does not use borrowed funds and avoids investing in instruments that use leverage or take a short position in the market, playing on the decline in the value of the asset.
Examples of passive investing
An asset allocation strategy is a passive investing strategy. This strategy is called bay and hold. Although such a single investment carries risks due to the limited set of assets. Buying even one share for the purpose of long-term retention and making a profit in the form of an increase in its value or receiving dividends will be a passive investment.
An interesting index investment strategy is buying an index (a set of assets). The structure of the index is such that the index provider makes changes to it from time to time. Let’s say that some stock leaves the index, giving way to another, due to some predetermined rules. For example, the Dow Jones Index is the aggregate of the value of thirty leading US companies. Since the formation of this index in 1896, its original composition has been constantly changing. The last company that was in its original composition, General Electric (ticker GE), only left the index in 2018. The index is a ready-made investment portfolio that you need to maintain on your account. ETFs are well suited for index investing, you do not have to think about a portfolio and buy individual stocks or commodities – to follow the index, it is enough to buy a share of such an ETF.
If you bought an apartment and rent it out for a long time, this can be considered a passive investment. Although the purchase of one apartment does not exclude the risk of downtime, non-receipt of income, changes in the attractiveness of the location of the apartment, etc.
A bank deposit can also be attributed to passive investment, although this is not entirely effective over long periods of time. The bank is a kind of intermediary between you and your money, and it takes money for its intermediation. Like a bank, you can independently buy certain assets – stocks, bonds, goods. In addition, the deposit rate is a market value, it can both rise and fall, which leads to a decrease in the efficiency of your investments.
If you are transferring funds into trust, this is passive investment for you. For you, yes, but not for your money. The manager can actively manage your money. That is, your participation is minimized, but your money will in fact be active. Calling such a passive investment is not entirely logical, since the risks increase in this case.
Passive investing and passive income
These are great terms, although passive income can be part of passive investing. Passive income is what the investor earns without making any effort. Passive income includes dividends from stocks, coupons from bonds, rent from renting out real estate, payments for intellectual property – patents, trademarks, works of art.
How effective is passive investing?
Passive investing is effective already because it does not imply active participation of the investor in portfolio management. The investor saves his time, he does not need to delve into the specifics of the market and the behavior of an asset on a daily basis. Its goal is to have an asset in its portfolio. The investor is confident that the asset or assets, despite occasional drawdowns in price, will be worth more and generate income.
With passive investing, the sale and purchase of assets is minimized, thus the investor avoids the risk of losing part of the income if he leaves the investment and returns to it at a price that would be higher than the selling price of the asset. Passive investing allows the investor to save time and nerves by avoiding sudden market movements.
The main issue in such an investment strategy is income generation. Much here depends on the diversification of assets, their coefficient of price correlation with each other, analysis of their behavior in different phases of economic cycles. And the most important component is time. Over a long period of time, market changes do not so much affect the final result: the longer the investor stays in the investment, the lower the risk of getting a bad result from the investment. This is a statistical fact. Especially if the investor takes a diversified approach.
Constant payments in investments
One of the effective tactics of passive investing is constant periodic payments for the purchase of an asset. Such contributions allow you to smooth out fluctuations in the price of an asset and get a more favorable average price than when buying an asset at the moment. This tactic is especially effective in a falling market: we do not know where the bottom of the market will be, but gradually buying an asset, we average the price of entering it. When the asset price reverses to growth, the return on investment will begin to rise. This tactic will allow you to avoid a psychologically difficult decision to enter an asset that is falling in price, but has growth prospects in the future.
Passive investments are great for beginners or investors who have a poor understanding of the market and its psychology and who are uncomfortable with actively investing, often changing their preferences. Sometimes it is better and more efficient to engage in passive investing than running around the market for momentary profits.