Investing can be a complex activity. There are various kinds of accounts, funds, and benchmarks that determine the outcome of your time and money. Moreover, when it comes to investing, there are different strategies that can appeal to different investors. Based on your income, future goals, risk capacity, family needs, and more, you could either choose passive investing or active investing. These two approaches differ starkly and are often chosen by investors of two opposing schools of thought. Here’s a brief explanation of the two to make things clear.
As the name suggests, active investing is when you are actively buying and selling stocks in order to gain a profit. Active investing involves timing the market vigorously to find the most lucrative opportunities. It requires proactive participation with a higher level of risk involved as investors try to gain profit from short term price variations.
Passive investing is the opposite of active investing. It involves buying a fund and staying invested in it for the long run. This approach usually comprises mutual funds, exchange traded funds, or index funds where the risk involved is comparatively low. Under this approach, you can invest your money in an instrument of your choice and then wait for its maturity to reap benefits. This form appeals more to people who have little understanding of the market fluctuations or who simply do not have the time, inclination, or risk appetite to take short term bets and study the market so closely.
If you fall into the latter category, here are 5 things about passive investing that a good financial advisor would advise you to know:
Since passive investing involves investment instruments, such as mutual funds, index funds, exchange traded funds, etc., it is not possible for the investor to have the freedom of choice of where the money is ultimately invested. It is the fund manager who decides where and when your money gets invested. If you are someone who likes to be in control and has discretion over where your funds go, you may like to consider active investing in stocks, where the buying and selling decisions lie with you entirely.
A primary factor that dictates the principles of passive investing is the timeline of your investments. Passive investing is all about buying an investment and staying invested in it for many years. Passive investing lets you benefit from the power of compounding and dollar cost averaging, so that you earn greater returns over the course of time. Another benefit of staying invested for a long time is the evasion of short term capital gains tax. As opposed to this, long term capital gains taxes are lower and ultimately let you enjoy higher rewards. Therefore, it may not be a sound strategy if your ultimate goal is a short term need. In that case, choosing an active investment strategy such as trading in the stock market may be a more suitable option.
With passive investing, you can diversify your portfolio with ease. Even with an investment in a single fund, your money is invested in the stocks of multiple companies. This offers more exposure to your portfolio and can be an effective way to reduce risk and the chances of losses. In this regard, passive investing is a much more stable option of the two approaches to investing. As a passive investor, your returns are consistent and steady over a period of time.
With passive investing, you can gain many advantages, such as low costs, more transparency, ease of investment, and better tax benefits. Passive funds use the index that they follow as their benchmark, resulting in lower costs incurred in management fees. This also enables more transparency as you can easily monitor the assets in the index. Moreover, since passive investing is a long term investment strategy, the tax liability generated from the returns is lower owing to the low interest rates of long term capital gains tax. In addition to this, as opposed to active investing, passive investment takes less time too. With active investing, you need to spend a considerable amount of time, timing the market and finding the right opportunities.
Passive investment is not for everyone. If you like taking matters into your own hands, following and timing the market, and having sole discretion on where to invest, then passive investing may not be ideal for you. Active investors make higher bets and take more risks to earn higher rewards, but with an indispensable possibility of loss. If you choose passive investing, you have to trust your fund manager to make the best decisions in your interest. You also need to let your investments sit untouched for many years in the future. If you keep withdrawing your money or feel the urge to sell your investments in a short span of time, you will never be able to fully benefit from your chosen passive funds. Passive investing is ideal for you if you prefer risk averse investment products, stable returns, and minimal supervision.
Passive investing is not a new approach. In fact, it has been in practice for decades now. But the popularity of mutual funds, exchange traded funds, and index funds has brought it to the forefront in the recent past. With passive investing, investors with little knowledge and time can also gain good returns from the market. However, it may be advised to keep a balance between active and passive funds to gain the best of both methods. Moreover, in order to choose the best opportunities and the right passive funds, it is important to take help from an expert. A financial advisor can help you pick out suitable passive investment funds that can help you reach your goals in the desired time.
If you are looking to begin investing passively, you can reach out to a professional financial advisor in your area.
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