What is passive investing?
1.- What types of investment are there?
When it comes to investing there are basically two ways, one on your own and the other by buying an investment fund, in this case we are delegating the investment of our capital to a manager. Regardless of the form of investment, there are two approaches: thepassive managementand theactive management.
In this article we are going to talk about passive investment, what it is, its differences with active investment, what are the instruments of passive investment as well as what are its advantages and disadvantages and at the end we will talk about who passive investment is appropriate for .
2.- Difference between active investment and passive investment
To explain what passive investing is, let's first see how it differs from active management.The main objective of active investing is to beat the market, that is, to obtain a return higher than that of the market average or that of its reference index. For example, if I only invest in shares of Spanish companies, the objective of my portfolio of shares will be to achieve a higher return than the reference indexIBEX 35.
The concepts that active investors use to try to achieve this objective are Stockpicking on the one hand and Market Timing on the other. Stockpicking means actively looking for theActionsof companies that they believe will perform better than the market average in the future. Market Timing means that active investors try to forecast when is the best time to buy and when is the best time to sell, that is, when a stock is at a low time to buy it and when a stock is at a good price. time to sell it. The main objective of Market Timing is therefore to anticipate market movements.
Both concepts, Stockpicking and Market Timing, do not exist in the passive investment strategy, since its objective is not to beat the market.Investing passively means obtaining the same return as the marketor that its reference index, in financial language is calledreplicate the marketor the index.
Returning to the previous example, passive investment will not try to predict which Spanish stocks will offer better returns than the IBEX35. If what we want is to invest in the market of the largest Spanish companies, investing passively means buying the IBEX35 reference index in its entirety. The Spanish market is neither the only nor much less the best that exists. There are benchmark indices for virtually every country in the world, for different regions, and even indices that replicate the global economy. If we want to replicate the economy of the whole world, we must buy an index that represents it, such as the MSCI All Countries World Index.
The theoretical foundation of passive investment is based on the theory of the efficiency of marketsofEugene F. Fame [The Fama Portfolio: Selected Papers of Eugene F. Fama], awarded the Nobel Prize in Economics in 2013. This hypothesis says thatfinancial markets are efficient by themselves and that the prices of financial assets traded in financial markets reflect all existing information. Since all investors have the same information, prices are perfectly valued, that is, they are neither over- nor undervalued. This hypothesis implies that it is not possible to beat the market consistently and in the long term.
This is obviously a very theoretical concept and as we all know, financial markets are anything but efficient. Even so, there are many studies, which show that less than 5% of all actively managed mutual funds have been able to beat their benchmark indices. Of course there are funds that have done this over the years, but past performance is never a guarantee of how the fund will perform in the future.
3.- The perfect instrument for passive investment
The instruments available to passive investment are thepassive management investment funds. There are two passively managed funds, theindex funds or index fundsand theETFs – Exchange Traded Funds. It is said that theETFs are the perfect instruments for passive investing on your own,since ETFs can be bought and sold on the Stock Market, in addition to the fact that ETFs are generally cheaper and more liquid than index funds. For this reason, we are going to focus from here on theETFsas a passive investment instrument. ETFs appeared in the 70s to solve the fact that most of theinvestment fundsthey could not beat their rate. Passive investing is the same as ETFs, blindly investing in stocks.Actionsthat make up the index as well as in their proportion and thus replicate the index and therefore its profitability. With the help of ETFs you can then buy entire indices and therefore get the performance of the index or the market. In this way you will be investing passively.
4.- Advantages of passive investment
Time
First of allpassive investing takes much less time than active investing. You do not have to carry out Stockpicking, nor individually search for financial assets nor follow the financial markets to buy or sell at the right time. What will take you the longest is the selection of the ETF, but otherwise it is an easy investment to make, for which you do not need to be an expert or invest many hours to invest in passive investment products.
Diversification
In addition, thanks to ETFs, passive investment has the advantage that it is intrinsically diversified.The fact of replicating the entire market considerably reduces the individual risk of each of the companies. If you buy, for example, an ETF from the MSCI World Index, you are simultaneously investing in more than 1,600 companies.
very low commissions
Another advantage of passive investing is the low costs. In investment funds you generally have to pay between 1% and 5% subscription commission and also the implicit commissions are relatively high. With the Exchange Traded Funds you areimplicit commissions are much lower and in most of them there is no subscription commission.
low capital entry
As a last advantage it is worth mentioning that passive investment requires a low capital input. With just €25 a month you can start investing passively and increase your assets.
5.- Disadvantages of passive investment
Doesn't beat the market
On the one hand you will never be able to underperform the market but on the other hand you will never be able to beat it either.
learning effect
The second disadvantage of passive investing is thesmall learning effect. When you actively invest, you gain experience faster. This disadvantage is offset by the fact that passive investing does not take as much time, time that you have for your personal enjoyment.
no ability to react
Another disadvantage of passive investment is that it does not have the capacity to react, that is, when a company suffers a bad run, the manager of an active investment fund would sell the share of that company to buy another. This does not happen in passive investing.
Slow equity growth
Slowness is another of the disadvantages compared to active investing and possibly the most important for people with little patience, sincewith passive investing you will not be able to multiply your money in a short period of timebut in exchange, the risk is much lower and the profitability is stable.
Reduced shareholder democracy
Finally, it must be said that passive investment harms democracy in the shareholders' meeting, sincevery rarely are ETF investors able to exercise their right to vote at the general meetingof joint stock companies. So there is more and more capital entered into companies that is not sufficiently represented in the general assembly.
6.- For whom is passive investing appropriate?
In conclusion, it can be said that passive investing is worth itespecially for beginners who do not yet have a great wealth or a great experience investing. It is a very simple way to accumulate experience without taking great risk and at the same time to slowly grow your wealth.
passive investing isalso highly recommended for those who do not have the time or the necessary knowledge or the interest in delving into financial matters but who nevertheless want to increase their wealthwith a sensible alternative to traditional ways of saving.
In the event that you want to start from 0, it is advisable to save at least €25 every month in an investment plan and periodically buy with them an ETF of your choice, such as an ETF on the European stock market or on the global market. In this way you accumulate your first experiences with the world of investment in addition to taking advantage of the effect of "Dollar-Cost-Averaging”.