Have you read somewhere the words passive investing and you want to understand what passive investing is about? In this post, I will explain the principles of passive investing so you can easily understand it even without any financial background.
Definition of passive investing
As I explained in the Active vs Passive Investing post, we can define passive investing as follows:
The investor takes a passive role, thus its name, by reducing the activity to a minimum, avoiding both the fees and the lower performance that come from frequent trading.
This is a good starting point, but I believe there is more to passive investing than that. However, to fully understand passive investing, we need to clarify two terms which you might not be familiar with.
First term – What is an index?
Consists of a hypothetical portfolio of securities representing a particular market or a segment of it.
If you are scratching your head after this definition, I will explain it with an example. The most famous index is the Standard & Poor’s 500. To cut it short, this index represents the 500 biggest companies in US stock market and weights them by their size (market capitalisation). For example, Apple, the biggest company, makes for around 3.5% of the index. The second biggest company, Microsoft, makes for around 2.5%. And the percentages go down proportionally until the smallest, which at the time of the writing is News Corporation Class B and makes for 0.007% of the total. Full list here.
Second term – What is an index fund?
Once you understand what an index is, it is pretty simple to understand what an index fund is. It is basically an investment funded by a group of people (we will call them shareholders) that tracks the performance of a certain index. So if you invest in an index fund that tracks the S&P 500, you will basically own a small part of all the 500 biggest companies in the US stock market.
So, what is passive investing?
As we said a few paragraphs above, passive investing is all about reducing the activity to a minimum. Index funds, as they simply track an index and do not intend to chase the new hot stock, are inactive, which makes them the perfect vehicle for a passive investing strategy. But, of course, there is much more to passive investing than simply saying that you use index funds. Being a firm believer in principles, I have underlined below what I believe to be the main principles of passive investing.
You can reduce the activity to a minimum.
- That leaves you free to do other more important things in life, such as building relationships or pursuing your dreams. In his book How a Second Grader Beats Wall Street, Allan S. Roth explains how the portfolio he created for his son consistently beat Wall Street. The most amazing thing is, they did not spend a single minute in it after setting it up.
Its aim is to track the market as closely as possible, not to beat it.
- This might seem like the worse idea ever, but it actually isn’t. Study after study shows that, on average, you are more likely to achieve a higher return (long term) with a passive investing strategy than with an active one. If you want a tonne of evidence, I suggest you buy Common Sense on Mutual Funds by John C. Bogle. It will blow your mind.
You can easily automate the whole process.
- Because you have chosen a passive investing strategy, the process can be automated so you can (and should) forget about your investment. Again, this might seem like a very bad idea, but it actually isn’t. Your Money and Your Brain by Jason Zweig explains all the mistakes that even the most experienced investors fall into due to the nature of our brains. Automating the process takes you out of the game, which long term is the best decision you can take.
When was passive investing created?
Although certain characteristics of passive investing have been around since the beginning of investing, it was the creation of the index funds that made the biggest leap towards a fully passive investing strategy. I believe this was the biggest leap because it simplified and popularised passive investing as none other creation could have done it. The first index fund was created by John C. Bogle (Vanguard) on the 31st of December 1975 and it tracked the S&P 500. Although named as “Bogle’s folly” at the beginning, it became the biggest fund in the world in 2000, 25 years after its creation. After another 17 years, it is still the biggest fund in the world.
How do I become a passive investor?
In following posts, I will explain step by step how to start with passive investing. It will surprise you how easy it is!