The Difference Between Passive Investing and Index Funds
How to Strategically Take on Risk as a Passive Investor
Passive investing and index investing are often discussed among investors. The former refers to a type of fund management, and the latter an investing strategy. Index investing is building a portfolio or fund based on indexes, like the Dow Jones Industrial Average.
Passively managed investments are funds or portfolios that are not actively managed by an investor or financial professional. Since index funds are built around solidly performing assets, they don't require as much attention as a fund built around investments that are not on an index.
There is risk involved in both passive and index investing, so it's essential to know more about each of the concepts and the risks involved.
What Is an Index Fund?
Stock indexes are lists of stocks hand-picked by experienced investors for their performance, return reliability, and longevity. There are several indexes, but the most popular are the Standard & Poor's (S&P) 500 and the Dow Jones Industrial Average.
The daily, weekly, monthly, and annual stock prices on these indexes are averaged and then tracked—this is the number you might see on daily stock news if they discuss the rise or fall of one of the averages.
Another popular index is the Russell 2000 index. This index is a list of small-cap businesses—companies with a small market capacity—that attract people interested in smaller business investing.
Index funds can be created from any investment type. U.S. Treasuries, municipal bonds, corporate bonds, and even specific market sectors like utilities or healthcare can be used to create index funds.
A fund is a pool of investments that a group of investors places capital in; the fund managers then put the money into the underlying assets. An index fund is a fund where the underlying investments are from the index on which it is based.
What Is a Passively Managed Index Fund?
If a fund's managers are continuously changing the underlying investments and moving capital around, the fund is actively managed. Passive funds are generally built around one of the stock indexes, which only change occasionally. If a stock is removed from an index and replaced, the fund managers will do the same.
A passively managed index fund is a fund that is based on an index that doesn't chase the latest trend; the managers make sure the underlying investments are always from the index it tracks.
Passively managed funds are not always index funds, but index funds are almost always passively managed.
Passively Managed Index Fund Risk
Over short periods, stock prices (measured by the stock market indexes) can have volatile swings up or down. Using the period from 1973 to 2009 as an example, the year that ended in June 1983 saw the best one-year return, which was 61%. The year that ended in February 2009 was the worst one-year period, with a -43% return.
Wild swings such as this account for the risks that are inherent in investing. Even passively managed index funds come with the risk of financial loss.
The chance that an investment will lose value is the basic premise of risk. When you purchase a stock, you don't know if it will gain or lose value. Passively managed index funds are designed to reduce the amount of risk an investor takes by tracking, or investing in, the stocks picked and placed on an index by knowledgeable investors and finance professionals.
The reduction of risk does not mean there is no risk. Passively managed index funds can and have lost value in market fluctuations.
Investing in a Passively Managed Index Fund
Investors generally accept index funds as lower-risk, long-term investments based on their underlying assets' historical performance. Some investors believe long-term investing is more risky than short-term, while others believe the opposite. Some investors believe in mixing both strategies.
Passively managed index funds are generally designed for long-term investing.
Many financial advisors or experienced investors suggest taking more risk when you're younger because you have more time to recoup any losses. When you're older, they advise taking less risk. These beliefs lead to five basic concerns about investing strategies:
- Long-term might be risky
- Short-term might be risky
- Mix short- and long-term strategies
- High risk is better when you're younger
- Low risk is better when you're older
To address these concerns with a passively managed index fund, you could create a portfolio of multiple index funds that address each issue. If you're younger, an example of how you could passively invest and allocate a 100% stock portfolio, called the asset allocation mix, across various index funds could look like this:
- 30% S&P 500 index fund—low risk
- 10% Mid-cap index fund—high risk
- 10% Russell 2000 or small-cap index fund—highest risk
- 20% Large-cap international index fund—low-risk
- 10% Emerging markets index fund—highest risk
- 10% International small-cap index fund—low risk
- 10% Real estate index fund—high risk
Bonds, such as U.S. Treasuries or corporate bonds, are generally accepted as low-risk investments. Bond index funds also exist, so as you age, you can reduce the stock index funds percentage and increase your percentage allocation to bond index funds, reducing the amount of risk in your portfolio and maintaining its overall value. This tactic is often referred to as tactical asset allocation.
What Is Your Ideal Asset Allocation Mix?
When you hear that you should take on more risk while you are young because you have more time to recoup, your asset allocation mix is being discussed. One of the simplest methods of determining how to allocate your portfolio assets is the 100-minus-age technique. You subtract your age from 100 and use the result as the percentage of stocks you should have in your portfolio.
Some have adjusted this technique to 110- or 120-minus-age to increase the risk and returns while you're young, and try to increase returns when you're older and have switched your portfolio to more bonds than stocks.
Another theory that can help you allocate your assets is the modern portfolio theory, which uses mean-variance analysis to minimize risk and maximize returns.