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Why Passive Investing Works

Updated: Aug 17, 2023

A brief history of passive investing, why it works, and how it stacks up against alternatives.


A brief history of passive investing, why it works, and how it stacks up against alternatives.


Investing can be quite complicated, as there are seemingly limitless ways to navigate it and an equally unlimited number of beliefs behind why we choose those paths.


And yet no matter how many different investment methods we create, each falls into one of two categories—passive or active.


Passive investment strategies can be less time-consuming than their active partners, and this method prefers to sit back and let the market do its thing. On the contrary, active investors and their strategies are out to try and beat the market at its own game.


While both routes have unique advantages, passive investing reigns supreme in most areas and has an all-encompassing grip on the present markets. Why is that, though?



Passive Investing History


Before the idea of passive investing, investing was just, well, investing. As time went on, investing became more and more intriguing to laypeople and scholars alike, quickly becoming a prominent area of study by the mid-20th century.


This progress gave way to boatloads of theories on how to do it best and led to some vital vehicles that helped transport passive investing to where it stands now.



Index Funds


Passive investing became official in 1976 when John C. Bogle, the founder of the new (1975) investment company Vanguard, created the first index fund called the Vanguard 500 Index Fund. The fund intended to mirror the performance of the S&P 500 without investors having to buy a single equity, let alone hundreds. More investment banks followed suit and began to offer their own index mutual funds.



ETFs


State Street took the first step and officially launched the SPDR S&P 500 ETF (also known as $SPY) in January 1993. Although it was a tough sell initially, ETFs have boomed massively in recent years, proving it was all worth it. ETFs are a more liquid version of index funds and allow investors to trade in and out of them like shares at any given time and for a lower fee—this last piece was a key next step in their evolution.



Passive Versus Active Returns


Recent data suggests that roughly 17% of the entire stock market is passively invested and is expected to surpass active trading by 2026. Meanwhile, ETFs are ~99% passively managed.



Broad data


Data from mid-2022 shows us that most actively managed funds were underperforming their benchmarks. 86% of all domestic actively managed funds were underperforming over the last 20 years. Dating back to 2021, during this euphoric time in the market, active funds held a temporary advantage over passive ones, but only recently. The further we go, the more those active funds lag the S&P 500.



Must know


Suffice it to say disappointment is not the case across the board for active investing. Although active investing cannot consistently beat the broad market on a large scale, there are examples of funds and fund curators that can win consistently—i.e., Warren Buffet and the like. An interesting tidbit, though: Warren Buffet is a fan of passive investing and backed his opinion up with a heavily tracked and very public bet.



The takeaway


It is possible to beat the market, but it’s challenging and statistically unlikely, especially over a long timeframe. Investors can most definitely hit a home run on a single stock at times or even pick a good active fund for some winning years, but passive investing’s low-stress consistency wins out.







Integrating Passive Investing Into Your Life


How you incorporate passive investing into your portfolio depends significantly on your situation and goals. Passive investing can be for everyone, but every portfolio has different needs, and you should choose a mix that makes you feel most in control of your investments.



Retirement


If you’re investing for the long run in a classic 401(k) and want the money to pile up with ease and simplicity, passive investing can handle that. For most people, passive is the best and safest security strategy for your golden years.



Mental


Passive investing is excellent for you if you’re easily bothered by market volatility and all the chaos that can hit your portfolio in times of uncertainty. When you center your portfolio on the broad market, you won’t have to worry about drastic swings as much as those more active, concentrated funds will.



Practicality


From a practical standpoint, passive investing makes sense for most of us. Unless you’re a fund manager yourself, your life is likely full already, and it’s hard to find time to manage a very active portfolio properly. Elsewhere, the success of an active investment can also come at the cost of some nasty tax bills—annually and upon cashing out at retirement.



Approach


Whether you’re old or young, there’s always a little appetite for thrill within us. Suppose your mind and pockets can withstand it. In that case, there’s nothing wrong with mixing in a little active investing and alternative options with your long-term portfolio, too—especially if you have your passive safety net to fall back on and are committed to watching and managing your stock positions.



Conclusion


Ultimately, everyone has their own situation to account for, and your investing style should be able to suit that. Having a passive strategy as the backbone of your overall portfolio is a great stabilizer.


But hey, the fact that you’re here with us now says a lot—you’re well on your way to financial wellness. There’s still room for improvement, and your app is a great place to start. Don’t forget to log in at least 3 minutes per week, and keep at your To-Do List!



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