“Slow and steady, wins the race.” This phrase is quite a relevant saying when it comes to passive investing.
Instead of being part of the rabbit race of constant trading, try taking the more steady route by investing for the long term and getting to be part of bigger returns. If this mentality suits you that you are in the right spot.
This article explores the meaning, benefits, and strategy of the passive investment approach.
What is Passive Investing?
The ideology behind passive investing is to try and create a portfolio similar to that of any underlying index such as NSE Nifty50, S&P BSE Sensex, or any type of commodity such as gold.
The investor tries to build the fund in a way that the returns will be similar to that of the benchmark indices and are also exposed to a diversified market.
Passive investing requires less monitoring as is created completely based n any robust index, thus, lowering the cost of requiring a fund manager.
This method also works to remove any type of emotional bias as the investor tries to follow the investment of known indexes and does not fall prey to any kind of emotional inclination towards a particular company or commodity.
Another benefit of this strategy is that it eliminates unsystematic risks. Systematic risk refers to the risks which cannot be mitigated and occur due to macro-economical factors like current account deficit or economical growth. The unsystematic risk, on the other hand, is more manageable.
It is usually the risk that occurs to due uninformed investment decisions or from a selection of wrong assets at the wrong time. Since passive investment tries to replicate the already well-performing indices, such unsystematic risks can be easily avoided.
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Features of Passive Investment
The positive characteristics of the passive strategy are as follows:
Diversified holdings: Usually, the index benchmarks are highly diversified, thus as the passive investment strategy tries to replicate the benchmarks, the portfolio becomes highly diversified. And diversification brings a proper balance between risks and returns.
Optimistic outlook: Indices are the representation of market sentiment; therefore, the replicated portfolio is bound to provide high returns over a long investment horizon. This is one of the core mindsets on which this investment strategy is based.
Less risky: Diversification almost always reduces risk because of its very nature. With more specialized index funds, investors can further diversify their holdings within industries and asset classes based on the funds they select.
Low costs: With passive, another feature that proves to be beneficial for the investors is the low transactional costs. This is because a passive investment strategy does not involve frequent trading and even the charges on ETFs are lower than 1%.
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Drawbacks of Passive Investing
Every coin has two sides, thus just like the positive points, passive investment also has a few drawbacks. They are listed below:
Too dependent on benchmarks: Regardless of the status of the markets, index funds adhere to their benchmark index. Meaning that passive funds will follow them without considering how the instrument is doing in the market. Loss in the market, therefore, equals a drop in profits.
Fewer windfalls: As passive investment follows the benchmarks, it is possible to not be able to capture the dips or rising stars of the stock market, which otherwise would have been possible with an active investment strategy.
7 Tips for a Successful Passive Investment Strategy
Passive investing has witnessed a higher return than active funds all around the globe. Such returns are possible for every type of investor if they are familiarised with these 7 key pillars of passive investment strategy:
Buy and hold strategy
One of the major mindsets that should be adopted when going for passive investment is to prefer to buy and hold over repeated buying and selling.
The thought process is based on the outlook that the financial market tends to perform well over the long term. If the performance of Sensex is considered then in the year 2000 the index stood at 5000 levels and today it is approximately at 53,000 levels. So, start preaching the buy-and-hold strategy.
The financial market requires fees for every trading transaction. But as passive investment follows the buy and hold strategy, there are lesser transactions, thus lower expenses.
And low expenses are equivalent to safeguarding your returns. Also, directly investing in passive funds limits the requirement for having a fund manager. Therefore, there is no active scheme that will eat away at your returns.
Higher returns over active funds
As previously pointed out, passive investment is all about buying and holding the investment.
This investment strategy requires you to have a long-term commitment and is ideal for investors who have financial objectives where long- and medium-term investments are beneficial for them.
Therefore, having a diversified portfolio with low costs and a long investment horizon will ensure returns which if not surpass, then replicate the market average returns.
Replicate index funds
The idea behind passive funds is to earn the same level of returns as index funds.
Thus, these funds are built in a way that just like index funds do not require any monitoring, the passive funds also do not need to be constantly watched. If you invest in it, simply leave it for the long term to reap good returns.
Mirrors the composition of index funds
The passive funds not just replicate the type of instruments in the portfolio but also the composition of the benchmark index. This way the returns from the passive fund will also be in line with the index.
This makes investment easy for beginners as they will not have to specifically pick stock after grueling analysis.
Reap the benefits of diversification
The passive investment involved creating a portfolio following a benchmark index. And as it is already known that index funds are diversified in nature, meaning the passive funds will also be diversified across multiple sectors.
Investor that diversifies their holdings is protected from downturns in a specific industry or company. Investors can significantly increase their profits by utilizing both this method and diversifying like actively managed assets, as opposed to just depending on the latter.
Transparent in nature
Active funds are completely monitored by the fund managers, meaning that you as an investor will not be able to exercise much control over the portfolio. This also reduces the transparency of the fund.
On the other hand, there is transparency when it comes to passive investments or investments in passive funds like index funds or ETFs because the investor is aware of the precise asset mix. It facilitates constant understanding and monitoring of the portfolio.
At a certain point in time passive investment was the go-to strategy for risk-averse investors, however, these days every investor, risk taker or risk averse, is openly adopting this investment strategy.
It is transparent, low cost, low maintenance, and helps reap bigger returns in the market. You tell me, who wouldn’t want to be part of a such profitable strategy?
So, without any further delay, go ahead and select your benchmark index and start investing in building your diversified portfolio.
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