Beginner's Guide to Passive Investing: Low-Cost Long-Term Wealth Building
Passive investing is an extremely straightforward method. Rather than attempt to beat the market by buying and selling nonstop, you are trying to track the market over time. Here’s a helpful way to think about it: If the market goes up 7-10% every year (the average annual return for the S&P 500 market index), then your investment goes up at that same rate as a passive investor.
There are three major advantages to passive investing. First, it is significantly less expensive than active trading. You aren’t paying management fees or transaction fees with each buy and sell, which can add up quickly. Second, it is less risky and produces better returns for a longer period than active trading because you are not gambling time or money on individual stock picking or timing the market. Third, you benefit from built-in diversification by virtue of investing in an index fund or ETFs given these generally invest in dozens to hundreds of companies.
What is Passive Investing
At its heart, investing in passive portfolios simply means buying and holding the investments that correspond to a market index, instead of trying to outrun the market. You are not selecting individual securities based on hot tips or trying to gauge which sectors will be booming next quarter. You are simply stating, "I think the whole market will grow in the long run, so I'm going to grow with it."
The characteristics of passive investing consist of index tracking (your investment mirrors a particular indices vs. actively picking and choosing individual securities) , long holding periods (you are staying invested for the long-term-no matter the ups and downs) and low cost (low fees lead to more money in your pocket).
The History and Evolution of Passive Investing
For quite a long time, passive investing was not the mainstream option it is today. However, in the 1970s it really blasted off (thanks to John Bogle/Vanguard). Bogle proposed a radical idea: what if rather than paying an expensive fund manager to pick stocks, I simply owned a piece of the entire market at very low cost?
In 1976, Vanguard started the first index fund that would be available to individual investors, the Vanguard 500 index fund. Critics--and there were many at the time--called it "Bogle's Folly", arguing that who would want to invest in an index fund and settle for average returns? But Bogle saw something most people do not see and pointed out that on average, after fees, most actively managed funds do not outpace the average market returns.
Advantages and Risks of Passive Investing
The Benefits First, low costs. Most actively-managed funds charge an annual fee of 1-2%, compared to many index funds and ETF's less than 0.1%. That's not much over a year, but over 30 years, high fees can eat up a third or more of your future return.
Next, stable returns. You will not beat the market, but on average, you shouldn't dramatically underperform it either. For the S&P 500, that has looked like approximately 10% annual returns on average over time (including dividends) over the last century. Some years you are up 30%, some years you are down 20%, but the long-term average is consistently very close to 10%.
Conclusion: Passive Investing for Long-Term Success
If there's only one takeaway from this guide, it is this: Numerous studies have confirmed that passive investing is safe and simple enough to accumulate wealth for the long haul. You will not become instantly wealthy, nor will you have exciting stories to tell your friends at parties. You will earn steady and predictable investment growth, which, when compounded over 10, 20, or 30 years, may become wealth.
The concepts are simply elegant: Purchase low-cost index funds or ETFs, invest regularly no matter the market conditions, keep your fees low, and give time to do its job. Simple as that—no complicated strategies, no market timing, and no stock picking.
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