The pros and cons of passive investing
Editorial staff, J.P. Morgan Wealth Management
- Passive investing seeks to maximize long-term returns while trading minimally. Unlike active investing, passive investing does not involve active management from a fund manager.
- Passively managed funds, like index funds and most exchange-traded funds (ETFs), track the market for relatively low-risk, low-reward returns.
- A passive investing strategy may allow you to mitigate market risk while simultaneously aiming for steady, long-term financial growth.
What is passive investing?
Passive investing, as the name implies, is an investing strategy that takes active, hands-on management out of the equation. In theory, the ideal passive investing strategy would be a fund that includes all possible assets you could invest in, allocated in proportions across the entire “investable universe,” or market portfolio of all tradeable assets. This is because a fund like this would have optimal market exposure, and it would therefore be able to track and even imitate the makeup and movement of a financial market index.
While this dream fund may not necessarily exist, there are real-life analogues that often serve as the foundation of a solid passive investing strategy. Quite often, individual investors who prefer to passively invest buy index mutual funds and exchange-traded funds (ETFs). These funds track broad stock market indexes like the S&P 500 and the Russell 2000.
What are the pros of passive investing?
Unlike an active investment strategy, which may or may not beat the market and can be expensive to maintain, a passive investing strategy is typically less risky and less expensive in comparison.
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Passive mutual funds and ETFs don’t require you to pay fund managers to manage them, so the associated fees are relatively lower. You can set up your brokerage account to purchase these investments automatically with the funds you deposit, and you can have the dividends from the funds reinvested as well.
Over a long period of time, passive investment instruments like index funds and ETFs historically try to match the returns of the underlying market or sector, offering relatively acceptable returns with less work and lower risk. However, it's important to note that past performance is not a guarantee of future results.
What are the cons of passive investing?
Passive investing is less risky, generally speaking – but as a result it can also be less rewarding. For example, if there’s a promising new company or sector that looks like it’s on the brink of sustained, exponential growth, a passive investing strategy won’t allow you to get in sooner than the rest of the market and end up ahead.
Passive investing isn’t totally risk-free, either, and an active investing strategy that includes hedging against market downturns might occasionally outperform a passive fund. This is because it has defenses against a market downturn built into it, which is something most passive investing strategies are not designed for.
Choosing the strategy that’s right for you
For many individual investors without the time or inclination toward in-depth investment research, passive investing is a low-cost investment method that typically generates solid returns. Younger investors – especially those who have decades to let their money grow before retirement – can put their money into an index fund or ETF and still reap the benefits of a long-term investment strategy in a comparatively low-maintenance way.
On the other hand, investors who do have the time to extensively research their investments or have more assets to invest may want to spend the extra time and money formulating an active investing strategy to potentially achieve relatively bigger returns.
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Editorial staff, J.P. Morgan Wealth Management
