Passive investing is a long-term wealth-building strategy all investors should know - here's how it works

• Passive investing is a long-term strategy in which investors buy and hold a diversified mix of assets in an effort to match, not beat, the market.
• The most common passive investing approach is to buy an index fund, whose holdings mirror a particular or representative segment of the financial market.
  
• Passive investing is the opposite of active investing, a more vigorous strategy offering bigger short-term gains, but greater risk and volatility.

If you can't beat 'em, join 'em.

That, in a nutshell, is the mantra of passive investing. This popular investment strategy doesn't try to outperform or "time" the stock market with a constant stream of trades, as other strategies do. Instead, passive investing believes the secret to boosting returns is by doing as little buying and selling as possible.

Passive investing, also known as passive management, may be laissez-faire - but it's not lazy. Its thoughtful, time-honored philosophy holds that, while the stock market does experience drops and bumps, it inevitably rises over the long hauls.

So, rather than try to outsmart it, the best course is to mirror the market in your portfolio - usually with investments based on indexes of stocks - and then sit back and enjoy the ride.

Simple to understand and easy to execute, passive investing has become the go-to approach for many investors. Here's how to join them.

What is passive investing?

The essence of passive investing is a buy-and-hold strategy, a long-term approach in which investors don't trade much. Instead, they purchase and then hang onto a diversified portfolio of assets - usually based on a broad, market-weighted index, like the S&P 500 or the Dow Jones Industrial Average. The goal is to replicate the financial index performance overall - to match, not beat, the market.

Perhaps the most common passive investing approach is to buy an index fund tied to the market. These sorts of funds are often known as passively managed, or passive, funds. The underlying holdings in passive funds can be stocks, bonds, or other assets - whatever makes up the index being tracked.

If the index replaces some of the companies included in it, then the index fund automatically adjusts its holdings, selling the old stocks and purchasing the new ones. Thus, investors profit by staying the course and benefiting from the market increases that happen over time.

Typically, index funds specialize in such areas as equities, fixed income, commodities, currencies, or real estate. Choosing different types of funds depends on the investor's desire for income or growth, risk tolerance, and needs to balance the portfolio.

Fixed-income bond funds generally act as a counterbalance to growth stocks' volatility, for example, while foreign currency funds can help provide a hedge against the depreciation of the US dollar.

Key features of passive investing

The ultimate goal of passive investing is to build wealth gradually, as opposed to making a quick killing. Key characteristics of a passive strategy include:

• Optimistic outlook. The core principle underlying passive investing strategies is that investors can count on the stock market going up over the long haul. By mirroring the market, a portfolio will appreciate along with it.
• Low costs. Thanks to its slow and steady approach and lack of frequent trading, transaction costs (commissions, etc.) are low with a passive strategy. While management fees charged by funds are unavoidable, most ETFs - the passive investor's vehicle of choice - keep charges well below 1%.
• Diversified holdings. Passive strategies also inherently provide investors with an efficient, inexpensive route to diversification. That's because index funds spread risk broadly by holding a wide array of securities from their target benchmarks.
• Less risk. By its very nature, diversification almost always brings with it less risk. Based on the funds they choose, Investors can also diversify their holdings further, within sectors and asset classes, with more targeted index funds.

Passive vs. active investing

An active investing strategy is the opposite of passive investing.

As the name implies, it means investors that engage in frequent or regular buying and selling, the better to outperform the market and profit from short-term changes in prices. Often, active investors attempt what's called "market timing": anticipating the stock market's moves, and trading accordingly.

Active investing, or active management, also characterizes many mutual funds and, increasingly, some ETFs. These funds are run by portfolio managers who generally focus on various specialized areas - say, individual categories of stocks or industries with growth potential. They constantly are evaluating, picking, and trading their portfolios.

Actively managed funds allow investors to benefit from the expertise of financial professionals with a considerably deeper understanding of the market and access to economic and financial analysis.

But actively managed funds are pricey. Thanks to all that buying and selling, they involve lots of transaction costs and fees. The average expense ratio for an actively managed equity fund is 1.4% compared to .6% for a passive fund, according to Thomson Reuters Lipper.

Also, there's the matter of risk: When managers seeking high returns bet correctly, the upside is big. If they don't, then they, and their investors, are out of luck.

In fact, actively managed funds, when fees are taken into account, tend to underperform their passive counterparts, especially in the US. One reason is that managers have to outperform the fund's benchmark index by enough to pay its expenses and then some. And that's hard to do. For example, in 2019, 71% of large-cap U.S. actively managed equity funds lagged the S&P 500, according to theS&P Dow Jones Indices' SPIVA (S&P Indices Versus Active) Scorecard.

Downsides to passive investing

While passive investing has a great many benefits, it has its drawbacks too.

• Live by the benchmark, die by the benchmark. Index funds follow their benchmark index regardless of the state of the markets. Translation: They'll rise when the index is performing well, and they'll also drop when prices decline. And if the whole market goes into freefall…
• Lack of flexibility. Even if index fund managers foresee a decrease in their benchmark's performance, they typically can't take such steps as cutting back on the number of shares they own, or take a defensive, counterbalancing position in other securities.
• Fewer windfalls. Since passive funds are designed to mirror the market, investors are unlikely to experience the big coups that actively managed funds can sometimes provide. No catching that rising stock star, in other words. Even if a fund did, it might not benefit as much, since the returns would be mitigated by the other holdings in the portfolio.
• Less pain but less gain. Buying and holding can be a winning tactic in the long run (at least a decade or two). You weather the market volatility. But evening out the risks also flattens out the rewards. In shorter time spans, active investing often provides better results and juicier gains.

A brief history of passive investing

Though buying and holding onto stocks is nothing new, passive investing as an official strategy first emerged in the 1970s with the creation of the first index fund for individual investors.

It was a new type of mutual fund, pioneered in 1976 by John C. Bogle, the then-CEO of investment company The Vanguard Group. Named the Vanguard 500 Index (VFINX), it allowed thousands of regular investors to buy shares in a fund that mirrored the S&P 500 - an index widely seen as a stand-in for the stock market overall. Priced cheaper than many mutual funds at the time, it enabled "the little guy" to have a stake in some of the market's best companies, without the cost of buying them individually, and without much effort.

Other companies followed suit in offering index mutual funds. Then, in the 1990s came another innovation: exchange-traded funds (ETFs). They, too, were designed to track various indexes - and with even lower management fees than mutual funds. And also greater liquidity, since ETFs trade throughout the day on exchanges, like stocks themselves.

Cheap, diversified, and low-risk, they were tailor-made for a buy-and-hold strategy - and vice-versa. It was the advent of ETFs that really made passive investing part of the financial conversation, especially for retail investors.

The financial takeaway

Passive investing has become the strategy of choice for the average retail investor. It's an easy, low-cost way to invest that removes the need to spend a lot of time researching stocks and watching the market.

The strategy's core tenet is that, over the long haul, the market's rise will reap financial benefits for those who wait. And that minimal trading yields maximum returns.

While the buy-and-hold approach has few downsides, it doesn't suit everyone. Ultimately, passive investing is better tailored for investors with long-term objectives, such as saving for retirement, and who prefer being hands-off.

Conversely, investors who want more hands-on control over their portfolios, or haven't got time for the waiting game, most likely aren't a good fit for a passive strategy. If they want to try beating the market and are willing to pay bigger fees to do so, an active approach is the way for them to go.