Investing can be a scary endeavor without a road map. That’s why it is so important to develop a solid investment strategy and stick to it. There are two main strategies for investing: passive and active. Most people don’t have the time to actively manage their own investment portfolio and having someone else actively manage your investments can be very costly over the long term. Passive investments such as index funds and ETFs are great investment vehicles for amateur investors looking to track the performance of the market or a certain market sector. In this article we’ll focus on passive investing.
Passive investing is often great for the beginning investor because it provides broad diversification with minimal costs. Passive investing is an investment strategy in which an individual makes as few transactions as possible. Buying and selling transactions are limited in order to minimize transaction costs and capital gains taxes. Passive investors follow a buy and hold approach when it comes to investing. They are seeking long term capital appreciation with limited activity. Passive investing can be used for just about any asset class including stocks, bonds, real estate, and commodities.
Investing With Index Funds
One of the most popular passive investments is an index fund. An index fund is a mutual fund that is designed to track the movements of a specific financial market by proportionally holding every security in a given market. For example, let’s say you were to purchase the Vanguard S&P 500 index fund (I picked this fund because it is one of the largest index funds in the world). You would be buying a fund whose performance would replicate the performance of the S&P 500. If the S&P 500 increased 10% during 2010 then the Vanguard S&P 500 Index Fund should be up approximately 10% as well. As you can see from this example, index funds aim to duplicate the performance of a given market.
Investing With Exchange Traded Funds
Another way to passively invest is through an Exchange Traded Fund (ETF). Exchange traded funds have been growing in popularity since the 90′s. They allow you to track an index like a traditional index fund but the price changes throughout the day just like a stock. Index ETFs can be purchased and sold anytime during market hours. Index mutual funds calculate their share prices at the end of the day so they can only be bought and sold after the market closes. The advantages of an index ETF are that the expense ratios and taxable distributions are typically lower than index mutual funds. For some more info, check out MainStreet’s take on ETF’s and some of the tax implications.
Most Popular Indices
DJIA – The Dow Jones Industrial Average is a price weighted average that tracks the movements of the 30 largest publicly owned corporations. This index is referred to on a daily basis when journalists report on whether the stock market is up or down.
S&P 500 Index - The Standard & Poor’s 500 index is a weighted index of the 500 largest companies that are widely held and actively traded in the United States. The S&P is a broader measure of the U.S. stock market.
Russell 2000 Index – The Russell 2000 measures the performance of the 2,000 smallest publicly traded companies in the United States.
Dow Jones Wilshire 5000 Index – The Wilshire 5000 tracks the returns of over 6,700 companies in the United States. The name can be misleading because the Wilshire Index used to only include 5,000 companies.
These are just a few of the most common indices. There are literally thousands of index funds and ETFs tracking all kinds of indices including commodities, financial, technology, bonds, international, and transportation.
The advantages of passive investing
- low turnover
- less decision making
- lower taxes
The disadvantages of passive investing
- index funds can never outperform the market
- subject to tracking error
What are your thoughts on passive investing? Is passive investing better than active investing? Do you think it is the right approach for you?