Unlike active investment, passive investment involves minimal interference in the investment process. This does not mean that it does not exist, but they minimize it. Passive investing comprises building a portfolio of assets.
Before getting down to passive investment, it is necessary to define what it is. If there are passive investments, then there are also active ones. Someone constantly involved in active investment means that the investor is in the investment process, choosing one or another asset.
Signs of passive investing
Passive investing is long-term: the longer the better. The investor does not take active actions in relation to this asset, does not use borrowed funds, and avoids investing in instruments that use leverage or take a short position in the market, playing on the decline in the asset's value.
Examples of passive investing An asset allocation strategy is a passive investing strategy.
This strategy is called buy and hold. Although such a single investment carries risks because of the limited set of assets.
Buying even one share for long-term retention and making a profit as an increase in its value or receiving dividends will be a passive investment.
An interesting index investment strategy is buying an index (a set of assets) suggests Joseph Marc Blumenthal. The structure of the index is such that the index provided changes it from time to time. Let's say that some stock leaves the index, giving way to another, because of some predetermined rules. For example, the Dow Jones Index is the aggregate of the value of thirty leading US companies. Since the formation of this index is 1896, its original composition has been constantly changing. The last company that was in its original composition, General Electric (ticker GE), only left the index in 2018. The index is a ready-made investment portfolio that you need to maintain on your account. It well-suited eTFs for index investing, you do not have to think about a portfolio and buy individual stocks or commodities - to follow the index; it is enough to buy a share of such an ETF.
If you bought an apartment and rent it out for a long time, we can consider this a passive investment. Although the purchase of one apartment does not exclude the risk of downtime, non-receipt of income, changes in the location's attractiveness of the apartment, etc.
A bank deposit can also be attributed to passive investment, although this is not entirely effective over long periods of time. The bank is a kind of intermediary between you and your money, and it takes money for its intermediation. Like a bank, you can independently buy certain assets - stocks, bonds, goods. In addition, the deposit rate is a market value, it can both rise and fall, which leads to a decrease in the efficiency of your investments.
If you are transferring funds into trust, this is a passive investment for you. For you, yes, but not for your money. The manager can actively manage your money. Your participation is minimized, but your money will in fact be active. Calling such a passive investment is not entirely logical, since the risks increase in this case.
Passive investing and passive income
These are grand terms, although passive income can be part of passive investing. Passive income is what the investor earns making no effort. Passive income includes dividends from stocks, coupons from bonds, rent from renting out real estate, payments for intellectual property - patents, trademarks, works of art.
How effective is passive investing?
Passive investing is effective already because it does not imply the active participation of the investor in portfolio management. The investor saves his time; he does not need to delve into the specifics of the market and the behavior of an asset daily. Its goal is to have an asset in its portfolio.
The investor is confident that the asset or assets, despite occasional drawdowns in price, will be worth more and generate income. With passive investing, they minimize the sale and purchase of assets, thus the investor avoids the risk of losing part of the income if he leaves the investment and returns to it at a price that would be higher than the selling price of the asset.
Passive investing allows the investor to save time and nerves by avoiding sudden market movements.
The main issue in such an investment strategy is income generation. Much here depends on the diversification of assets, their coefficient of price correlation with each other, analysis of their behavior in different phases of economic cycles. And the most important component is time. Over a long period, market changes do not affect the result so much: the longer the investor stays in the investment, the lower the risk of getting a poor result from the investment. This is a statistical fact. Especially if the investor takes a diversified approach.
Constant payments in investments
One of the effective tactics of passive investing is constant periodic payments for the purchase of an asset. Such contributions allow you to smooth out fluctuations in the price of an asset and get a more favorable average price than when buying an asset at the moment. This tactic is especially effective in a falling market: we do not know where the bottom of the market will be, but gradually buying an asset, we average the price of entering it. When the asset price reverses to growth, the return on the investment will rise. This tactic will allow avoiding a psychologically hard decision to enter an asset that is falling in price but with growth prospects in the future.
Passive investments are substantial for beginners or investors who have a poor understanding of the market and its psychology and who are uncomfortable with actively investing, often changing their preferences. Sometimes it is better and more efficient to engage in passive investing than running around the market for momentary profits.