David Morey 
Passive investing is considered the silver bullet by many in the finance universe. Look around and you’ll see thousands of investors praising this strategy for its simplicity, low costs, and track record. Just set it and forget it; the market will do the rest! But before you switch to passive investing, here’s something to mull over: Is this strategy truly 100% safe, or is it just an illusion?
Fundamentally, no investment strategy is 100% safe. Even alternatives like passive investing carry some form of risk. If you are considering becoming a passive investor, you should first familiarize yourself with the downsides and limitations of the strategy. This guide from InvestingGuide will introduce you to everything you need to know before switching to this strategy..
What is Passive Investing?
Passive investing is an investment strategy that revolves around matching the performance rather than beating it. The most common assets here are exchange-traded funds (ETFs) and index funds. Here’s an example of how passive investing works:
Suppose you want to invest in stocks. If your primary strategy is passive investing, you can buy an ETF like the Vanguard S&P 500 ETF (Ticker: VOO), which contains shares of some of the biggest brands in the US, from Apple and Alphabet to Microsoft, Johnson & Johnson, and Tesla. By investing in this asset, you own a broad slice of the market, and your investment grows based on the overall market performance.
Passive investing has 2 key features: minimal trading and minimal management. As a passive investor, you buy and hold assets for a long time – you don’t buy and sell frequently, which is what active investors do. Plus, you spend less effort and time managing your investments.
Why Passive Feels Secure
Many investors consider passive investing to be safe and sensible for the following reasons:
- Broad diversification: Passive investing mainly involves ETFs and index funds, and these instruments consist of baskets of different assets. Investors consider this strategy safe because if you buy either, you invest in a wide range of brands, which minimizes risk exposure.
- Minimal management: There’s minimal management in passive investing, as we’ve discussed earlier. This translates into lower fees, allowing investors to pocket most of their returns. The same aspect also reduces the hassle of constantly worrying about the best time to buy low and sell high, an incredibly draining endeavor.
- Track record: Short-term ups and downs aside, the most popular assets in passive investing, indices, have a long history growing over time. Their track record has built investor confidence and made passive investing the safest strategy for many.
- Less emotional decision-making: Constant decision-making isn’t predominant in passive investing. That is a good thing since, when making decisions constantly, emotions like greed and fear often can cloud your mind as an investor and override logic, causing ill-advised moves.
Popular opinion leans towards passive investing being the safer alternative, and in many ways, it is. But that doesn’t mean it’s risk-free or a foolproof strategy for building long-term wealth. This strategy has numerous hidden risks that no one should overlook. Let’s dissect some of them.
Market risk
Assets like ETFs might expose you to the perks of diversification, but they won’t shield you from market risk. The market may take a dive at any moment, and your portfolio will suffer. Remember, passive investors lost money when the trade tensions between the US and China reached fever pitch, with assets like iShares MSCI Emerging Markets ETF (EEM) experiencing the worst dips in years. Simply put, you’re not immune to macroeconomic downturns as a passive investor.
Overconcentration
Most index-based assets popular in passive investing comprise the most prominent companies globally. So, while investing in them, your investment is often not as diversified as you think. Most of your money will be tied to a considerable number of big players and their fortunes.
If one or more of the giants in your basket of assets stumbles due to issues like disruptive competition, your portfolio will definitely take a significant hit.
No built-in defense
The biggest flaw of passive investing is that it focuses on going with the flow; it doesn’t try to outsmart or react to the market. That can be beneficial when the markets are calm; otherwise, it can be a major issue. Suppose your portfolio as a passive investor consists mostly of stocks from the tech sector. If the sector overheats, your passive investment will follow the initial momentum until the bubble bursts and everything goes downhill, including your portfolio.
False sense of security
As mentioned earlier, most investors consider passive investing a safe strategy. Unfortunately, if you base everything on this belief, you are more likely to “set and forget.” This is risky because if market conditions change suddenly, your portfolio may depreciate significantly before you realize it and make the necessary adjustments. That is why you should schedule regular check-ins and reviews, even when relying on passive investing as your primary strategy.
When Passive Might Not Work Well
Passive investing can be a splendid strategy in certain conditions and situations. For instance, it can do you a world of good when you’re investing in the long haul and don’t have time to research or trade frequently. But it might not work well in some instances.
For starters, passive investing can fail to take you where you want to go as an investor during market bubbles and excessive valuations. If you rely exclusively on this strategy in such situations, you will likely incur significant losses when the bubble bursts and a sharp correction occurs.
Passive investing might also be unsuitable and fail to work in your favor if you like taking advantage of unique market opportunities. That is because this strategy focuses on tracking an index or basket of assets. If you use it exclusively, you will miss out on undervalued stocks and other golden opportunities at some point.
Conclusion
Passive investing has, without doubt, earned its reputation. It’s something you should consider, especially if you don’t have the time or knowledge needed to trade frequently. But be overconfident in this strategy because it’s not foolproof. Various risks go hand in hand with it, from overconcentration to vulnerability to overvaluation. Before harnessing the potential of passive investing, understand the risks involved. Also, consider your investment goals, risk tolerance, and liquidity preferences.
