The Difference Between Passive Investing and Index Funds

How to Strategically Take on Risk as a Passive Investor

Hand putting money in to jars marked "college" and "401k"
•••

JGI/Jamie Grill/Getty Images

Passive investing and index investing are two buzzwords in the financial world. The former refers to a type of fund management; the latter is a 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. Index funds are built around solidly performing assets. This means 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. Learn more about each of the concepts and the risks involved.

Key Takeaways

  • Stock indexes are chosen by experienced investors. Then, they’re averaged and tracked over periods of time to gauge performance.
  • Indexes are pooled into a fund where they collect capital from investors that’s placed in underlying investments by the fund managers.
  • Passively managed index funds tend to be less risky because they’re based on historical performance.
  • Your portfolio should show balance and be allocated over various types of investments.

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.

Note

Index funds can be created from any investment type. U.S. Treasuries, municipal bonds, corporate bonds, and even specific market sectors like utilities or health care 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 most often built around one of the stock indexes. These 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.

Important

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. Wild swings such as these account for the risks that are common 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 buy 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. That's because it tracks— or invests 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 often 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,; others believe the opposite. Others prefer to mix 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:

  1. The long-term might be risky.
  2. The short-term might be risky.
  3. Mix short- and long-term strategies.
  4. High risk is better when you're younger.
  5. Low risk is better when you're older.

How can you address these concerns with a passively managed index fund? You could create a portfolio of multiple index funds that address each issue. If you were on the younger side, for instance, let's look at how you could passively invest and allocate a 100% stock portfolio across various index funds. This is also known as asset allocation. Your mix 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 often accepted as low-risk investments. Bond index funds also exist. As you age, you can reduce the stock index funds percentage and increase your percentage allocation to bond index funds. This can reduce the amount of risk in your portfolio and maintain its overall value.

What Is Your Ideal Asset Allocation Mix?

You may often hear that you should take on more risk while you are young because you have more time to recoup. In this case, your asset allocation mix is being discussed. One of the simplest methods of deciding how to allocate your portfolio assets is the 100-minus-age technique. You subtract your age from 100. Then, 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. This can help increase the risk and returns while you're young, It can also 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. This uses mean-variance analysis to minimize risk and maximize returns.