Passive investing can mean a couple of different things depending on the context, but the core idea is the same: instead of trying to beat the market or actively manage every investment decision, you are generally trying to capture market returns in a simple, low-cost, and efficient way. In stocks, that usually means using broad index funds that own essentially all the stocks in a market rather than trying to pick winners. In real estate, passive investing might look more like investing in syndications, private funds, turnkey rentals, or hiring out management instead of personally finding properties, renovating them, screening tenants, and managing day-to-day operations yourself. There is really a whole spectrum of passivity, with some investments requiring almost no involvement and others still needing occasional oversight.
When it comes to mutual funds and stock investing, the evidence strongly favors passive investing over active management. Passive index funds provide instant diversification, low costs, daily liquidity, and professional management while avoiding the constant challenge of trying to outperform the market. Over the long run, most actively managed funds fail to beat simple index funds, especially after taxes and fees are taken into account. This has proven true not just with large US stocks, but across international stocks, bonds, and other highly analyzed asset classes. Broad-based index funds that track the entire stock market or total international markets tend to work especially well because they own both the winners and losers and simply capture the overall growth of the market over time. Even many professionals with advanced tools, research teams, and experience still struggle to consistently outperform these simple passive strategies.
There are still situations where active management may make sense, particularly in private investments where index funds do not really exist. Real estate, small businesses, oil and gas investments, and other private opportunities often require more active decision-making because there is no simple total market fund available. Even then, many investors can still participate in a relatively passive way by using syndications, private funds, or professional managers. For most investors though, especially beginners building their first portfolio, broadly diversified low-cost index funds remain the foundation of a smart investing plan. One of the biggest mistakes investors make is either trying to pick individual stocks themselves or using narrow, niche indexes that concentrate risk into one sector or theme. Broad total market investing may not be exciting, but it has historically been one of the most reliable ways to build wealth while freeing up your time to focus on your career, family, and life outside investing.
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You often hear the phrase passive investing or passive management, as opposed to active management or active investing, and in reality we're talking about two different things here. Okay, sometimes the phrase passive is used to refer to kind of an index fund strategy, right? When you're investing in stocks, for instance, you are, you know, just buying all the stocks via an index fund and trying to match the market rather than trying to beat the market. However, the term also gets used, particularly in real estate strategies. Right, you can be a passive investor or you can be an active investor. If you're an active investor, you're going down, looking at a house down the street, evaluating it, making an offer on it, buying the thing, maybe you're going in there and you're renovating it. Now you're finding a tenant, you're interviewing the tenant, you're putting together a contract for that tenant, maybe you're going out and trying to hire a property manager to assist you, and you know, after a few years, you know, maybe you got to replace the tenant, or maybe you want to sell the property, so you got to go sell it, right, that's a very active way to invest in real estate, as opposed to, you know, just hiring a passive manager to do that sort of thing for you, and there's all kinds of, you know, there's a whole spectrum of passive ways to invest, whether you're just buying a turnkey property that already has a tenant in it and already has a manager set up, or whether you're buying a real estate syndication or a private real estate fund, or just investing into a real estate index fund, right. There's a whole, you know, continuum of ways to invest passively, with each step being a little bit more passive.
So this term can apply in more than one way, but mostly what we're talking about here is we're talking about mutual funds, which is the easiest way to invest, probably the way that most people should invest, and probably the way most of us should have most of our money invested. Right, mutual funds give you a lot of advantages, they give you instant diversification, they give you daily liquidity, they give you professional management, they give you economies of scale, because you're banding together with 1000s or millions of other people to invest in this investment, but there are two kinds of mutual funds, right? There's passive mutual funds, there's active mutual funds. Passive ones are generally just trying to get the market return, keep costs low, get you the market return for that particular type of investment, whether that's stocks or bonds or real estate or whatever, whereas an active manager of a mutual fund is usually trying to beat the market, at least on some sort of a risk-adjusted basis, and so they usually own fewer stocks in an actively managed stock mutual fund than a passively managed index mutual fund.
The index fund, this passive manager computer, mostly just buys all the stocks, it's essentially easy to guarantee yourself the market return, you own all the winners, yes, you own all the losers, but over the long run you tend to have good returns that are going to help you reach your goals, and in fact, when you compare these two approaches, particularly when it comes to stock mutual funds, you realize pretty quickly that the smart way to go is to invest passively, because even before tax, in the long run, you're beating 90 95% of those active managers, and after taxes it's even higher, plus you don't have to worry about manager risk, you don't have to monitor as much, there's all these benefits to using these index funds and investing in a passive way, so it's very clear when you look at the data, particularly when it comes to investing in stocks, and I'm not talking about just US large cap stocks, I'm talking about all kinds of stocks, you know, international stocks, US stocks, the data is even pretty good for bonds, it's not quite as good for bonds as it is for stocks, but it's very good when it comes to these frequently traded, commonly owned, highly analyzed asset classes like stocks and bonds, that the approach to take is passive. It really does work better in the long run, almost all the time, and it's probable you're in that almost all the time category.
Now, there are some funds that are kind of passive, you know, the more passive they are, the cheaper they tend to be, the better they tend to outperform, but you know, there's always a continuum of passivity, you'll see some index fund providers or passive fund providers, such as Avantis or DFA, you know, some people call them indexing light or something like that, because they have a passive strategy, but kind of an active way that they implement it, and so there are some mixes where there's a little bit of active going on along with passive, and that's okay, the point is you got to recognize just how difficult it is to predict the future to pick stocks that are going to beat the market.
As you move away from these highly analyzed asset classes, index funds often aren't available, right? There is no index fund for all of the duplexes in your hometown. If that's the type of investment you want to invest in, you're not going to be able to invest in an index fund to do that, that doesn't mean you can't invest passively, you know. If you find somebody else is building syndications or a fund of these things, or if you're just hiring, you know, a turnkey company to run them for you, or you know, hiring out as much of the management as you can. There are other ways to invest passively, even in the asset class that doesn't have index funds, but keep in mind if you are in an asset class that does have index funds, that's probably the way to go. That's why 85% of our portfolio is in boring old broadly diversified low-cost index mutual funds and ETFs, because it's just such a smart way to invest.
Okay, so when might active management make sense? Well, if you think you have some edge that is going to help you beat the market, I guess active management is how you implement that edge, but mostly the times to use it is just when you're investing in something where, you know, an index fund is not available, and that usually means some sort of a private investment, whether that's real estate or oil and gas or a small business or some other thing like that, but if you're a beginner building your first portfolio, the way to start is broad-based index funds, we're talking total stock market index funds, total international stock market index funds, bond index funds, those are the building blocks to build your portfolio in the beginning, and even now, 20 plus years later, those are still the biggest building blocks in our portfolio.
Just recognize that a lot of investors out there are making big mistakes when it comes to this question, right? The mistakes usually are just picking an active manager, or worse, trying to pick the stocks themselves and being that active manager. These professionals can't do it with all their fancy computers and high-paid assistants and all their expertise and degrees. What makes you think you're going to be able to do it in between patients? You're not going to be able to, and frankly, neither are they, probably, when you compare it to an index fund.
So, the first mistake is just actively investing when you should be passively investing, but other mistakes get made as well. Sometimes people don't pick the right types of indexes to follow. Right, I'm a big fan of broad-based indexes, you know, the ones that buy all the stocks in the US, for instance, but there are other indexes out there, such as indexes that follow the Nasdaq index, right? That's not all the stocks in the US, it's just the ones that trade on one stock index. It tends to be very tech company heavy. It's not a broad-based index, so I'm not a big fan of that index, nor of index funds that follow it. The Dow Jones Industrial Average is well known, it's been around a long time, but it's not a broad-based market index, it's just like 30 big stocks, is all it is. So, I would encourage you not to buy an index fund that follows that one, or some little niche index funds, right? If you're just buying an index fund that invests in semiconductor companies from Taiwan, right, that's very niche, and yes, if those companies do well, you're going to do well, but that's a bit more of a gamble than just buying all the stocks when you're using a total market kind of approach.
Hope that's helpful in learning to understand the difference between active investing and passive investing, and really the advantages of passive investing that not only help you beat active investing returns, but free up your time and allow you to use your time actively, because you're investing your money passively.
The White Coat Investor Podcast is for your entertainment and information only, and should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.
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