Passive investing has advantages that give it the potential to out-produce an active investing approach -- but only if it's done correctly. Because passive investing epitomizes "buy and hold," choosing the right investments from the start is crucial to generating those high returns.
What is passive investing?
Passive investing is an investment strategy that seeks to minimize transactions. The idea is to pick out the right investments and hang onto them as long as possible, only replacing them if it becomes clear that the investments are no longer worth holding.
Since passive investors have few transactions, they also have minimal expenses to erode away their returns. Fees, commissions, and capital gains taxes all occur largely as a result of transactions, so if you have no transactions, your costs will be much lower than an active investor's.
Even if your reported returns are somewhat lower than those of said active investors, you can still come out ahead thanks to your much lower expenses. For example, if your portfolio returns 7% this year and your neighbor's actively managed portfolio returns 10%, it might seem like you didn't do as well as he did. But if your fees and taxes were just 0.5% of the total portfolio value while his totaled 4%, you outperformed him in the final analysis.
So how can you make your investments work for you through passive investing? Here are five tips for getting started.
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1. Choose index funds/ETFs
Since a major advantage of passive investing is lower costs, it's important to maximize that advantage wherever possible. Index funds and ETFs provide a powerful way to do so. Because these funds are themselves passively managed, expense ratios are typically much lower than those of actively managed funds. And while a passive investor could simply pick out his own stocks, he's likely to get far better diversification by buying into a few different index funds instead.
2. Seize every tax advantage
And while we're on the subject of cutting costs, reducing your tax bills can help you save a significant amount of money every year. The easiest way to reduce tax-related investment expenses is to keep the bulk of your investments in a tax advantaged account such as an IRA, 401(k), or HSA. All of these accounts allow you to collect dividends and interest without paying taxes on the money as it comes in and exempt your investments from capital gains taxes. Tax-deferred accounts such as traditional IRAs and 401(k)s give you a tax break on the money you contribute, while Roth versions of these accounts give you your tax break on the withdrawals. HSAs provide tax breaks on both contributions and withdrawals, making them the only triple-tax-advantaged account.