Passive investing is a investment strategy which consists of replicating the behavior of an index or a market, without trying to outperform it or anticipate its movements.
In this article, Algo Global explains what passive investing is, how it works, its advantages and disadvantages and which financial products you can use to apply it.
What is passive investing and how does it work?
Passive investing is based on the efficient market hypothesis, which holds that financial asset prices reflect all available information and that it is impossible to beat the market consistently and sustainably.
Therefore, passive investment seeks to obtain the same profitability as the market, without assuming more risk or incurring more costs.
Passive investment works by replicating an index or a market, which is a set of financial assets representing part or all of a sector, a region, a category, etc.
For example, the S&P 500 is an index that groups the 500 largest companies in the United States, and the IPC is an index that groups the 35 most representative companies in Mexico.
To replicate an index or a market, passive investment can use two methods: physical replication or synthetic replication.
The physical replication consists of buying all or a representative sample of the assets that make up the index or market.
The synthetic replication consists of using derivative instruments, such as futures or swaps, that replicate the performance of the index or market without the need to purchase the assets.
What are the advantages and disadvantages of passive investing?
Passive investing has advantages and disadvantages, which can be summarized in the following points:
Advantages
Passive investment has a lower cost, as it avoids management fees, purchase and sale transactions, taxes and other expenses associated with active investment.
It has a greater diversificationas it allows access to a wide variety of assets, sectors, regions, etc., reducing specific risk.
It is also more transparent, as it is based on objective and measurable criteria, rather than on opinions or predictions.
Disadvantages
Passive investment has a lower potential return, as it is satisfied with obtaining the same return as the market, without taking advantage of the opportunities that may arise.
In addition, it has a higher systemic risk, as it is exposed to market fluctuations, without being able to avoid or mitigate them.
Its flexibility is less, since it depends on the composition and weight of the assets that make up the index or the market, without being able to adapt to changes or investor preferences.
What financial products can I use for passive investment?
In order to apply passive investment, there are several financial products that can replicate an index or a market, with different characteristics, advantages and disadvantages.
Some of the most common financial products are as follows:
- Index fundsThese are investment funds that physically replicate an index or a market by buying all or a representative sample of the assets that make up the index or market. They have a low cost, high diversification and high transparency, but also a low potential return, high systemic risk and low flexibility.
- ETFsThey are exchange-traded funds that physically or synthetically replicate an index or a market, using derivative instruments or buying the assets that compose it. They have low cost, high diversification and high liquidity, but also low potential return, high systemic risk and low flexibility.
- Robo-advisorsThey are digital platforms that offer an automated investment advisory and management service, using algorithms and mathematical models. They have low cost, high diversification and high customization, but also low potential profitability, high systemic risk and low transparency.
What is the difference between passive and active investment?
Passive investing and active investing are two different strategies for investing in the stock market.
Passive investment consists of replicating the behavior of an index or a market, without trying to outperform it or anticipate its movements. It has the advantage of lower cost, greater diversification and greater transparency, but also the disadvantage of lower potential returns, greater systemic risk and less flexibility.
Active investing consists of choosing and buying buying individual stocks with the intention of outperforming the general market. It has the advantage of higher potential returns, lower market exposure and greater flexibility, but also the disadvantage of higher cost, less diversification and less transparency.
How can I choose between a passive or active investment strategy?
The choice between a passive or active investment strategy will depend on your investor profile, your objectives, your time horizon and your level of risk.
Passive investing consists of replicating the behavior of an index or a market, without trying to outperform or anticipate its movements. Active investing consists of picking and buying individual stocks with the intention of outperforming the general market.
Passive investing has the advantage of lower cost, greater diversification and greater transparency, but also the disadvantage of lower potential returns, greater systemic risk and less flexibility.
Active investing has the advantage of higher potential returns, lower market exposure and greater flexibility, but also the disadvantage of higher cost, less diversification and less transparency.
In order to choose one of the two options, it is recommended to take into account elements such as investment knowledge, risk appetite, and the profitability you wish to obtain, among others.
