Passive Investing

Passive investing is an approach to owning securities in which the investor makes no attempt to identify mispriced securities and no attempt to time entries and exits, holding broad rules-based positions instead and leaving them alone. The claim being made is a negative one: not that the market is always right, but that the investor is not going to try to be right about which parts of it to own or when.

The naming is worth being precise about, because there is no definition to look up. The Securities and Exchange Commission's investor glossary has no entry for the phrase, and where the SEC does use the word it applies it to funds rather than to people, saying that index funds "follow a passive investment strategy designed to achieve approximately the same return as a particular index before fees," and that passive management "usually translates into less trading of the fund's portfolio (lower transaction costs), more favorable income tax consequences (lower realized capital gains), and lower fees and expenses than actively managed funds." That is a description of how a fund is run. Extending it to describe an investor is ordinary industry usage rather than a regulatory category, and nothing turns on the word legally.

Indexing is a property of the instrument. Passive is a property of the behavior. The two are treated as synonyms constantly, and the gap between them is where most self-described passive investors actually sit. An index fund only tells you that the fund follows a published list of rules. It says nothing about why its owner bought it this month, whether they will still own it next quarter, or whether the list covers a whole market or one industry in one country.

So consider two people who own nothing but index funds. The first holds a broad stock fund and a broad bond fund, contributes on the same date every month, and looks at the balance twice a year. The second holds eight sector and single-country index funds and shifts between them as the outlook changes. Both own passive instruments. Only one is investing passively, and the second is making exactly the two bets the approach is defined by declining. The cost of that second stance, and what it takes to win it, is the subject of active investing rather than this page.

What indexing does not decide. A reader who adopts the approach expecting it to answer the hard questions finds that it answers a narrower one than advertised. Still open, and consequential: how the money is split between stocks, bonds and cash, which is the asset allocation decision and the one that shapes both growth and volatility; which index, since a total-market index, a large-company index and a single-sector index are all indexes; how much goes in and how often; what the rule is for restoring the target mix after markets move it, which is rebalancing; and which account each holding sits in, since the tax treatment differs. None of those is answered by choosing to be passive. What the approach does is convert them from continuous judgments into a small number of decisions made once and reviewed rarely.

There is no fully passive position, and pretending otherwise obscures a real choice. Every index is a set of rules that a committee or a methodology wrote, and choosing among them is a choice about what to own. A total-market index embeds a definition of which securities count as investable. A large-company index embeds a size cutoff. Holding US stocks only, or holding them alongside international stocks at market weight, is a decision either way, including when it is made by not deciding. The honest version of the idea is not that no decisions are made but that few are, they are made deliberately, and they are not revisited because of what happened last week.

In practice the approach is a short written set of rules and then the discipline to follow them. Choose a target mix of asset classes. Choose broad holdings that track wide indexes rather than narrow ones. Decide how much is contributed and when. Decide in advance what will trigger a trade, which is ordinarily either a calendar date or the portfolio drifting a stated distance from its target. Then execute the rules rather than reacting to the news.

A hypothetical illustration of what following a rule looks like. Priya sets a target of 80% stocks and 20% bonds and writes a rule that she will rebalance whenever either holding drifts more than 5 percentage points from its target. She starts with $100,000, which is $80,000 in stocks and $20,000 in bonds.

Stocks then rise 25% to $100,000 while bonds are flat at $20,000. The portfolio is worth $120,000 and stocks are 83.3% of it ($100,000 divided by $120,000). That is 3.3 percentage points above her 80% target, inside her 5-point band, so her rule says to do nothing and she does nothing. Had stocks reached 86%, the same rule would have told her to sell some and buy bonds, and she would have done that too without forming a view about which way markets were heading. The rule, not the forecast, is what makes the position passive.

Pros

• Removes the two hardest judgments in investing, security selection and timing, by declining to make them.
• The decisions that remain are few and durable, so the approach survives periods when an investor is busy, distracted or frightened.
• Low trading means fewer realized capital gains in a taxable account, which the SEC names as one of the ordinary consequences of passive management.
• Results are easy to explain after the fact, because the portfolio did what its written rules said it would do.

Cons

• You accept the market's outcome in full, including every decline, with no mechanism intended to sidestep one.
• The label invites a false sense of completion. An investor who has bought index funds and stopped thinking has not chosen an allocation, a contribution rate or a rebalancing rule.
• "Passive" carries no guarantee of breadth. A single-sector or single-country index fund is a concentrated holding whatever its management style.
• Following a rule through a long decline is harder than writing one, and the approach only works to the extent it is actually followed.