What is passive investing?
Passive investing is an investment strategy which, as you would expect, involves investors setting up their portfolios to be as close to entirely passive as possible, mostly by investing in an index that follows the overall stock market performance, that way they can focus on getting more money to invest in the first place.
Both active and passive investing have their place in the market, but each investing strategy has it’s own strengths and weaknesses.
Publicly listed companies have a certain number of shares available for the people to buy and sell. Investors, traders, portfolio or fund managers, as well as ordinary people can buy and sell these stocks.
Buying a share at a certain price and then selling it at a higher rate is at the crux of making a profit. This is the foundation of the entire economics of the stock market.
However, one can also choose to hold on to a dividend paying stock for a considerable period of time, or buy-and-hold a position in an index fund, instead of trying to sell it quickly to secure a substantial profit. Holding onto a stock and waiting for a reward in the long run, in the form of dividends, is passive investing.
Active investing, on the other hand, is the practice of buying a share, after analyzing the prospect of its appreciation in the short term, and then selling it for a better price. Thus, one makes a profit.
Passive investing does not require an immediate or short term appreciation of the price of a share. One can buy a stock, or a certain number of shares, dollar-cost average their share purchase price, hold onto the equity for months, or years in some cases, and continue to earn money through the dividends paid by the company. When the stock price has appreciated generously in due course of time, the investor holding onto the equity can choose to sell, or retain it to keep earning the dividends.
A brief history of passive investing
The concept or practice of passive investing didn’t exist until the 1950s. Remember, the first stock market index wasn’t even established until 1976, so these strategies and investment vehicles are relatively new, in the grand scheme of things.
Up until the Second World War, almost everyone trading in stocks was into active investing. People would buy and sell shares to make a profit. There was an unprecedented economic and industrial boom during the peacetime decades following the war.
Not only did the boomer generation flourish during these years, the stock market too expanded like never before. One of the first proponents of passive investing as a strategy was Harry Markowitz, with his introduction of the ‘Modern Portfolio Theory’ in 1952.
This was the first time an economist floated an idea that was contrary to active investing. His advocating in favor of risk adjusted returns found many endorsements.
A decade or so later, Eugene Fama came up with his ‘Efficient Market Hypothesis’. One must note that mutual funds had already become popular in the fifties and sixties.
Fama stated that active investing, which is basically predicting favorable returns on the basis of stock prices fluctuations in the short term, could not be a sound strategy for the long haul. Both Markowitz and Fama argued that it is nearly impossible to keep outsmarting the market with limited information.
It was inevitable for people to lose money more frequently than earning a profit with such a strategy.
Harry Markowitz and Eugene Fama would go on to become Nobel laureates in economics. Burton Malkiel, another celebrated economist, endorsed the researches, findings and theories of Markowitz and Fama.
In his 1972 book, ‘A Random Walk Down Wall Street’, Malkiel illustrates how historical prices of shares or stocks have absolutely no power to predict the fate of those equities, not in the short term and certainly not in the long run.
By the end of the seventies, passive investing had already been endorsed by many institutional investors, including Warren Buffett. Through the late seventies and early eighties, Buffett was en route to become a billionaire and he became one, officially, in 1986, proving the validity of value/passive investing, if anyone had still doubted it.
A Random Walk Down Wall Street - Burton G. Malkiel
Is passive investing right for you?
Compared to active management, it is MUCH easier to become a decent passive investor.
Active investing is tough. It requires a lot of time, substantial capital, plenty of research and understanding of the market, quick decisions that can go horribly wrong and a penchant for risk, which does not come naturally to those who have limited cash to spare.
Active investing has its merits, but so does passive investing. In the long run, passive investing tends to be more rewarding with far fewer risks.
Anyone who wants to become rich, or financially independent in a true sense of the term, should consider passive investing, but I’m not a financial advisor, so don’t take my word for it!
For a trader to make a lot of money every month by buying and selling shares in a short span of time, there is a need to have a massive capital that can be churned whenever needed.
Most people don’t have a massive amount of capital lying around, which makes it a little complicated to become a successful day-trader.
Prices of shares fluctuate very little during intraday and day-to-day trading, unless there is a crash or a sudden spike, which makes it impractical to get huge windfall returns without having a lot of capital.
If an investor doesn’t have over $25,000 in their portfolio, they are limited to 3 day-trades per week, which can be somewhat bypassed by using multiple brokers, but still, it’s hard enough to be a successful day-trader even when they allow you to trade when you want.
Passive investing, on the contrary, allows a person to hold on to a stock for years. If a stock is chosen wisely, then its price can appreciate from a few dollars to hundreds of dollars over the decades. One does not have to constantly chase the narrow margins offered by daily or intraday fluctuations.
There is never enough information available in the public domain to make accurate predictions. Insider trading is illegal. It is practically impossible for any one person to always have all the information related to the stocks or the companies that may be of interest.
Passive investing apps
If passive investing sounds like your cup of tea, we have written an article that lists the 3 apps we think are best for passive investing, so please check it out and let us know what you think.
If day-trading sounds like a better fit for you, then check out our Webull review because Webull is one of the few investing apps that is designed to function as a day-trading platform.
Thank you for reading!
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