The Motley Fool

What Is: Passive Investing

At The Motley Fool we spend a lot of time researching and investing in individual companies. We believe this is the best route for investors that want to beat the market. After all, you don’t win the Champions League by grabbing every footballer in the world — you just get the best.

But investing in individual stocks isn’t for everyone. Some people don’t have the time to devote to learning about companies and keeping up with them. Other people simply don’t have the interest — they’d rather be watching football… or playing football themselves.

That doesn’t mean that those people shouldn’t invest in equities — far from it. Instead, they are prime candidates to be passive investors.

What does a passive investor look like?
Unlike the “active” investors that spend time in research and buy and sell individual stocks to try to beat the market, “passive” investors don’t bother trying to beat the market, they just buy the whole market.

Say what?

Thanks to the advent of index funds and ETFs, investors have the opportunity to buy large groups of stocks — the DAX 30, the FTSE 100, the S&P 500… or essentially the entire world through indexes like the MSCI World index.

These index funds are set up so that they mirror the index that they’re named after. So when that index goes up, the index fund follows, and when the index falls, so does the fund.

Besides the ease that index funds provide, there’s also the huge advantage that reputable index funds are extremely low cost. As compared to the typical actively-managed mutual fund, which can charge investors an ongoing management fee of 1% or more (sometimes much more!), you can often find index funds that charge fees of 0,2% or less. The iShares DAX (EPA: SDX) charges investors a mere 0,16% per year.

How big of a deal is that? Very big. If you have a €100.000 fund holding that’s charging 1% per year, you’re being charged €1.000 every year for holding that fund. Trade that in for the iShares DAX — or a comparable low-cost index fund — and you’ll be paying just €160 per year.

That’s a big difference in just year one. But the difference gets even bigger over time. Assuming you earn the 9% average annual return that the DAX has seen over the past 30 years, after 10 years of owning the higher-cost fund, your €100.000 would have turned into €214.100. But thanks to the lower fees of the index fund, the money there would have grown to €232.976. That €18.876 difference is money that’s better in your pocket than the pocket of a fund-management company, don’t you think?

It’s also how they buy
Passive investors don’t just differ from active investors in what they invest in, it’s also how they invest.

Active investors may vary how much they’re putting into the market over time. By studying the valuations of the companies that they’re interested in, active investors may buy like maniacs when the market price is below the company’s intrinsic value. At other times, when the market price is too rich, those same investors may sit on their hands and wait for better opportunities.

Some active investors also take a “macro” view of investing by looking at the performance of certain industries or the economy as a whole. They hope to use various economic reports and indicators to discern when environment is ideal for investing and… well, when it’s not.

Passive investors don’t worry about any of this. Instead of trying to figure out the “right” or “best” time to invest, passive investors simply invest in the market consistently. One specific method that many passive investors use is Euro-cost averaging. With Euro-cost averaging, you simply invest the same number of Euros every month — or quarter, whatever — in your index fund of choice, come rain or shine.

The advantage here is that you take tricky emotions out of the equation. Sure, sometimes you may end up investing when the market is overvalued. But, assuming you stick to the plan, you’ll invest just as much when the market is undervalued and most investors are too scared to invest. The idea is that over time, it all balances out and you benefit from the overall growth of the German, and world, economy.