Passive investing involves a strategy of investments that involves limited ongoing selling or buying of stocks.  These investors make their purchases with the intention of holding onto the investment for long term appreciation with very limited maintenance.

This type of investing is also known as the couch potato or buy and hold strategy.  It requires the investor make good research before buying, have patience and invest in a portfolio that is well diversified.

Where active investors may look to make a profit from price fluctuations that occur over a short period, passive investors purchase the security with the belief that it will be profitable in the long term.

Active vs passive InvestingIn the English language active and passive are opposites.  The passive investor chooses to take actions that others do not choose.  Active investment lives by the belief that the market is inefficient.  It acts on the belief that smart investors are able to find undervalued stocks and purchase them.  In addition, they believe that the investor can discover overvalued stocks to avoid or sell short.  This is the process of stock selection.

Investors who are active in their approach also try to outsmart market timing.  If the bull is about to enter the arena, they will purchase their stocks before the rally.  At the same time, if they believe the bear is about to emerge from hibernation, they avoid the stocks.  Market timing, combined with stock selection is active management.

Managers of active investments may choose several strategies or factors by which their portfolios are comprised.  They might include PEG ratios or P/E ratios, sector investing and selection of stocks from companies currently out-of-favor or perceived to be selling at lower values.  Other strategies include short positions, asset allocation, option writing and merger arbitrage. 

Active investing can give a far greater return, although the risk is much higher.

Suba at Wealth Informatics has this debate well laid out at Are Passive Investors Smarter Than Active Investors

Also good view point for passive investing by Tushar Mathur is here at Why Passive Investing Beats Active Investing


Underlying Theory

The underlying theory of passive management is that the markets are very efficient.  Thus, the passive investor believes that the security’s market price is the best available estimate of the correct prices and it is unlikely to be product to try to outperform the market once the expenses of trading rapidly are added in.

A second definition of Passive investing is:  A strategy for investment the involves limited selling or buying on an ongoing basis.  Passive investing involves purchase of securities with a long term appreciation strategy that involves limited maintenance.  Passive investing can involve purchase of mutual funds or ETF that are indexed and holding onto the security for a long time due to the predetermined allocation of the asset. There are various passive investing strategies that you can definitely follow.

Passive Funds vs. Actively Managed FundsIn mutual funds, the difference in the passive funds and actively managed ones is that the passive fund will include all the stocks that are included in the S&P 500 index or any such similar index.  The active fund usually picks from 100 to 200 of the top funds listed.

Passive investing and Indexing

From the standpoint of an investment strategy, traditional ETFs are used to track the indexes.  ETFs are sold in many different varieties and track almost any index that can be imagined.  Each offers the benefits that come with mutual funds that are indexed, such as a low rate of turnover, lower price for broad diversification and significantly lower expense ratios.

The original concept of the ETF was providing one security able to track the trades and indexes intraday.  Use of intraday trading allows the investors to sell or buy essentially every security making up the entire market, such as the Nasdaq or S&P 500 by making one single trade.  This allows investors additional flexibility to change their position at any point during the day, unlike traditional mutual funds , which are traded only once daily.

Benefits of Passive Investing

The passive investing strategy is growing in popularity, especially with institutions, and for good reasons.  The results over the long term show this to be a favored strategy, especially in the area of bonds and large capitalization stocks.

Many investors are looking to join this strategy as it is hard to beat the S&P 500.  Some passive funds to consider to make use of this investment strategy include the Fidelity Spartan Index or the Vanguard Index Fund.

While it might be possible for an individual investor to do better than the S&P 500, the low cost gives even more strength to passive investing.  Other investing involves taxes, commissions, trading fees and research costs, all reducing the overall return to the investor.

For further reading on Passive investing take a look at the works or Larry Swedroe and Rick Ferri. Rick;s most recent book is called the The Power of passive Investing and is a must read.