Investing in the stock market is a bit counter-intuitive. It would seem that the investor that puts in more time and effort managing his investments should have an edge over other investors. However, this extra effort actually can create serious problems. A more hands-off strategy typically works out better for most investors. This is the power of passive investing.
Active vs. Passive Investing
An active investor is trying to get above average market returns by constantly buying and selling stocks. He hopes to find the most profitable stocks on the market through research and market timing. The problem with this is that only half of investors in the stock market can be above average each year. If your picks go wrong, you can earn less than the average return of the market. The stock market is full of professional traders with years of experience. How confident are you that you will consistently beat the market average?
A passive investor, on the other hand, is not trying to get exceptional returns. He is usually content to buy and hold a portfolio of investments for the long-term. Index funds are popular investments for passive investors because they deliver the exact return of a market. This isn’t a bad strategy for steady, long-term growth because the average market return is quite high. According to the Federal Reserve, the stock market has earned an annual return of 10% over the past 50 years. Not bad for just buying an index fund.
Every time you buy and sell a stock, you need to pay a brokerage fee. In addition, if you sell an investment for a gain, you need to pay taxes on your gain. Lastly, if you hire a professional to manage your money, the more time he spends managing and researching your investments, the more it will cost. All these costs add up and are a significant drag on active investors. This is why in 2011, 79% of portfolio managers didn’t beat the return of the market they were trading on, according to the financial web Morningstar.
A passive investor has very low costs. Since he trades rarely, he does not need to pay much in brokerage fees or in income taxes. If an active investor and a passive investor earn the same return for the year before fees, the passive investor will come out way ahead after you subtract fees. This is one of the key advantages of passive investing.
The key to good investing is keeping your emotions under control. Your decisions should be based on your research, not on spur of the moment panic or excitement. However, as any investor knows, this is easier said than done. If you are constantly checking up on your stocks, it is easier to get carried away by your emotions. When your stocks are going through the roof, you will be more tempted to buy high. When the market is crashing, you will be more tempted to sell off too much of your portfolio. If you are a passive investor and don’t check your portfolio often, you won’t be as affected by the daily swings of the market. This makes it easier to focus on a disciplined, long-term strategy.
In investing, slow and steady wins the race. While a passive investment strategy won’t yield any huge one-year gains, it will earn a steady profit on your money. By removing the costs and emotions of active investing, passive investing gives you a better chance of hitting your long-term goals.