Passive investing has unsurprisingly gained significant attention and growth in recent decades — it’s perceived as simple, low cost, and full of long-term benefits. Many investors equate passive with "do it yourself" and market-cap weighted index strategies like the S&P 500. However, this perspective doesn't quite capture the full scope and potential of passive investing. As you navigate the investment landscape, it's crucial to understand the true essence of the passive strategy and how to make the best use of it.
The Essential Characteristics of Passive Investing
Passive investing is distinguished by several essential principles that make it such a successful methodology for investing. These characteristics include:
Time in the Market, Not Timing the Market
One of the core tenets of passive investing is the buy-and-hold strategy, where investors focus on maintaining their investments over the long term, rather than attempting to time the market. The aim is to reap the returns that are naturally generated by investing, which by definition includes lending to entities and owning profit-generating companies.
Diversification is at the core of passive investing with the objective of minimizing risk. By spreading your capital across a wide range of assets, you avoid putting all your eggs in one basket. This approach reduces the temptation to play smart by picking certain investments while avoiding others.
Passive investing seeks to minimize costs by avoiding paying high fees for active management or attempting to outsmart the market. Instead, the objective is to participate in the entire market of production at the lowest possible cost.
Challenging the Market-Cap Weighted Index Approach
The modern understanding of passive investing often involves investing in market-cap weighted indexes like the S&P 500. To elaborate further, market-cap weighting is an approach to investing where allocation towards companies is based on the size of the company (i.e. if Apple’s company size is two times that of Amazon, the index/investor simply invests two times more in Apple). Each company's weight in the index is based on its market capitalization, also known as the company’s overall dollar value. This means that larger companies have a more significant impact on the index's performance. The most popular market-cap weighted indices include the S&P 500 and Nasdaq.
However, choosing to invest in a market-cap weighted index is not entirely passive; it's an active decision to adopt this specific allocation methodology which has its own downfalls. We could still harness the benefits of passive investing whilst also incorporating the benefits of other allocation methods, such as professional active management, equal weighting or multi-factor weighting.
Expanding the Passive Investing Horizon
To truly embrace passive investing, we’ve got to both consider its core benefits while exploring alternative allocation methodologies:
The Multi-factor-weighted approach looks beyond ‘bigger are better’ and instead considers multiple different factors for determining allocation, such as:
- Value: the Warren Buffet approach focusing on investing in undervalued companies.
- Quality: having a preference to own companies that have consistent earnings.
- Size: investing in smaller companies within competitive sectors to have more upside.
- Momentum: over-allocating towards companies that have recently done well over the short-run. Data shows that these companies usually continue such trends.
The multi-factor methodology aims to further improve diversification and return by combining the benefits of these various investment factors.
Professional active management
The traditional passive approach often stays away from professional active management, primarily due to associated costs. However, professional active management fees have gone down over time and can definitely offer substantial benefits. A professional management team can make decisions based on fundamentals and explore factors that have yet to be defined, driving future performance. Especially in complex markets, active management has a proven track record.
Incorporating a Good Advisor
There are several cases to be made for incorporating a professional advisor to your investment strategy, though most simply a good advisor can increase the value of your returns more than the cost involved. Choosing a competent, ethical, and client-focused advisor can also help guide you in asset allocation, cost-effective implementation, behavioral coaching, and goal-based planning, ensuring your unique needs and aspirations are addressed.
Passive investing, while offering simplicity, cost-effectiveness, and long-term benefits, is not just about investing in market-cap weighted indexes. By exploring alternative allocation methodologies and incorporating the value of a good financial advisor, investors can reap the benefits of a truly passive approach and enhance their investment outcomes.