How to Make Money in Stocks | What is Active Investing?

What is Passive Investing?

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If the stock market seems daunting to you, it may be because there are so many choices. Which of the tens of thousands of available stocks is right for you? Which businesses will make money and which are teetering on the edge of bankruptcy?

It's tempting for people to go to a professional money manager for advice—even to make their trades for them—but the fees you pay for this service aren't often worth it. Sure, he or she will pick investments for you and make trades for you, based on an understanding of your goals and risk prospect, but are you getting what you pay for? Are you getting the investments that are right for you, or the investments that someone wants to sell you?

Fortunately, there's a better way to invest that doesn't take much effort on your part, earns respectable returns, and doesn't waste your money paying for advice you don't need.

Passive Investing Defined

Passive investing is a strategy of buying low-cost, high-value stocks and funds and holding them over a long period of time. It's characterized by a few important features:

  1. The purchased securities tend to grow over time due to the strength of the businesses they represent
  2. The period of holding tends to be years or decades
  3. There are few transactions over this time—no blips of buying or selling

If you were to start today at age 25, you could put $10,000 in a low-cost S&P 500 index fund and wait 40 years until you retire with a nice nest egg. That's as simple as this can be. Yet there is nuance to this technique.

Advantages of Passive Investing

The main advantage of this approach is its simplicity. It's easy to explain; pick a couple of good securities to buy, make the trade, and wait. You're in the investment for the long term; there's no need to look in the newspaper every day to see the closing value (just kidding; no need to check your favorite finance site on your phone every few minutes).

It's also easy to continue to invest, with a strategy such as dollar cost averaging. Add your $100, $500, or $1000 every month and you'll get the benefit of more invested over time. If you've already found a great place to put your money, why not keep investing there? This is very compatible with dividend reinvesting. Some funds even reinvest those dividends for you.

As you're not making lots of trades besides just your regular purchases, you won't face as many taxes as if you bought and sold often. (Depending on how you invest, you may have to pay annual capital gains taxes on dividends.)

Finally, passive investing is very compatible with a 401(k) account through your employer. Most plans allow you to select from a couple of good funds, such as the aforementioned S&P 500 index fund or a small cap fund. While these funds aren't necessarily as good as the Vanguard gold standard, their fees and costs should be as low as anything else in the fund list.

Disadvantages of Passive Investing

This approach does have some drawbacks. Your rate of return from passive investing will tend to fluctuate between 6% and 10% with the S&P 500 index fund over time. That's not a bad return at all, but it's also not the best return you can find in the market. Yet given how much effort it takes to invest passively, it's a good, solid return over time.

As alluded to earlier, the available options in an employer-sponsored plan aren't necessarily the best options available from a discount stock broker with your own plan. Then again, maxing out your 401(k), especially with employer-matching funds, is already a good deal for many people. (Besides, if you leave your employer, you can roll your 401(k) into a self-directed account and have access to the entire market.)

One subtle but important drawback of this passive approach is that you're often tying your financial fortune to the strength of the US economy. While the S&P 500 index gave great returns in 2012, 2013, and 2014, it looks to finish off 2015 having lost money over the year. That can be disheartening to see on paper, but if you're putting in money every month, you're buying the US economy at a discount—and you're investing in the long term, so you can ride out a few rough years here and there. That may be worth it for your perspective, even as an active investor might hold a few stocks that have done really well in 2015.

Should Value Investors use Passive Investing?

Is a passive investing strategy compatible with value investing? It can be! The diversification of investing in a broad market index fund lets big winners even out big losers somewhat, and it puts your dollars in the stocks of the biggest and best US businesses. Unless you're already extremely wealthy, you're not going to own significant stock in Apple, GE, Exxon, Facebook, Google, Coca-Cola, et cetera anywhere else.

The expected long-term returns of passive investing are decent, certainly worth the minimal effort it takes to get them, but if you're capable of and interested in managing some of your own investments, setting a 15% return goal is also possible.

In that case, a hybrid approach might be warranted. Find a threshold, perhaps half of your portfolio in a broad index fund, a quarter in a different fund, and a quarter to play with as an active investor. Maybe the ratio is 40/40/20, or whatever makes sense for you. Whatever you decide, the simplicity of passive investing—especially in a low-cost, low-churn fund—can be a real advantage to earn decent returns and protect your capital while you pursue great individual stocks at good prices.