Passive Investing: The Ins & Outs of Building Your Passive Income

Whistle while your investments work. For hundreds of years, we’ve been drawn in by the idea of making money while sitting on something of a nest egg, and passive investing is one of the most pertinent ways of generating a profit without the burden of constant trading. 

In a nutshell, passive investing is an investment strategy that’s designed to maximise your returns by minimising the need for buying and selling. One of the most common passive investment strategies can be found in index investing, where investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon. 

(Chart showing distribution of passive and active open-end funds worldwide, from 2011 – 2020. Image: Statista)

So what actually is passive investing? And is it a viable way of building your savings? Here’s an in-depth look at this investment method:

What is passive investing?

Passive investing methods aim to generate a level of wealth while avoiding fees and the limited performance that may occur with frequent trading. The overall goal of passive investing is to build wealth gradually and is sometimes referred to as a buy-and-hold strategy. 

Unlike the case with active traders, passive investors are more patient, and avoid looking to profit from short-term price fluctuations or market timing. The assumption behind a passive investment strategy is that the market will post positive returns over time. 

Those who manage passive investments typically believe it’s too risky to attempt to anticipate the twists and turns of the market – so they try to trace market or sector performance instead. Passive investing often consists of diverse portfolios of single stocks, which would be crafted with an extremely intensive degree of market research. 

The arrival of hedge fund solutions in the 1970s made that act of achieving returns within the market considerably easier. In the 90s, exchange-traded funds, or ETFs, that track major indices, like the SPDR S&P 500 ETF (SPY), made the process even simpler by enabling investors to trade index funds as if they were stocks. 

Pragmatic investment

Passive investing has a proven track record of steady success – just ask the likes of Warren Buffet, Jack Bogle, John Templeton and Peter Lynch. 

If you’re something of an industry novice then that’s okay too – it’s easy for investors to place their money into an index tracker fund, like the aforementioned SPDR S&P 500 and sit on it for a couple of years before checking out your profit margins. The omens are good that this form of investment will be successful, too. In fact, according to S&P Dow Jones Indices, passive investors typically outperform 86% of large-cap active fund managers across the market – without having to splash out on sizable management fees along the way. 

Relative ease

You don’t have to be a stock market guru to invest passively (although it would admittedly help a little). Academics and long-term investors are sceptical of the success that ‘timing’ produces for those of us who look to ride the speculation and cash in on the next big boost. 

As Investopedia agrees, the market is an extremely random place and even if some success can be forged, a market-timer would need to be accurate almost three-quarters of the time in order to effectively ‘beat the index.’

This acts as an effective advert for passive investors. Similarly to buying a house, buy-and-holders take a wider look at the overall characteristics of the market and weigh up its prospects for future growth and then let their investments do the talking – without the fear of trying to bide their time effectively for the ideal exit and entry. 

Easy taxation

Another added bonus of holding on to investments on a long term basis comes from the fact that passive investing is great for capital gain over time. If you hold an investment for over a year before selling, it will be eligible to be taxed at a considerably more favourable rate – as opposed to a higher short-term rate. 

Locking away your capital

Of course, passive investing is not without some drawbacks. Notably, investors are locking away their capital over a long period of time by embracing passive investing. 

This means that investors must not only be certain that they won’t need the money that they’re investing in the short term, but will also need to be confident in having no reason to require access to their funds in the long term either. 

It also means that your money won’t be available if you identify a new investment opportunity to funnel capital into. Essentially, passive investing actually requires a lot of discipline and plenty of restraint in enabling your investments to grow naturally. 

Longer timeframes

To build on the point of locking away your capital, the approach of passive investment is very time-intensive. Holders will not only be required to hold their assets for a long period of time but after ten years of living with their capital funnelled into one portfolio, for instance, there’s no guarantee that there will be a profit waiting for them. 

It’s possible that you could pay ten years down the line for making a poor long-term investment decision when setting up your passive income portfolio.

Sometimes even the most experienced investors can draw a blank – and with this in mind, it could be effective for them to diversify their portfolio to help ensure better exponential growth within their account. However, even when adopting this approach, a high-performing investment can be nullified by being tied in with a poor performer. 

Fundamentally, it’s essential that you make a carefully thought-out decision on where to invest your capital, or you could pay through a considerable loss in revenue further down the line. 

Be wary of downturns 

The chances are that you’ll remember the economic downturn of 2008 very clearly. There are warnings to be heeded by passive investors here too. Just because you’ve held your stock or index fund for seven years, it doesn’t mean that there’s no danger of your capital disappearing tomorrow. While it would take a pretty catastrophic event for the markets to be wiped out completely, we’re living in a time of enhanced volatility, and as such, crashes do occur every-now-and-then. 

If a correction occurs, leading to an extended bear market, the ramifications could be dire for the capital sitting in passive investing portfolios. If such a disastrous situation were to occur, investors may become overwhelmingly attached to their assets and decide to average down in the hope of an upturn in fortune.