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Passive investing: A crucial retirement investment strategy misunderstood by nearly everyone

Carla Fried, Rate.com on

Published in Home and Consumer News

A survey of nearly 6,000 households asked, in multiple choice format, the definition of “passive investing.” More than half chose “didn’t know.” Another 29% incorrectly chose “buying and holding without being influenced by short term market fluctuations.”

Only one in five retirement savers, in the quiz by Hearts & Wallets, correctly identified passive investing as “investing in an index, often weighted to market capitalization.”

A wrong answer on this one has big financial repercussions. People who didn’t know the definition of passive investing were less likely to be tucking away money in an individual retirement account. And those who were investing tended to hold a lot more cash than stocks — a great way to lose ground to inflation.

Understanding passive investing and making it the centerpiece of your strategy can add tens of thousands of dollars to your retirement pot. Good news: It’s not hard to grasp, and it’s easy to implement.

When you hear “passive” think “index.”

When you’re investing for retirement, chances are you own mutual funds. Workplace retirement plans, such as 401(k)s, offer a lineup of mutual funds, or their close cousin, a collective investment trust. Mutual funds are also a popular choice for individual retirement accounts (IRAs) you own directly through a brokerage account.

 

Each mutual fund you own typically owns dozens, if not thousands, of individual stocks and bonds. That makes mutual funds a super easy way to own a diversified portfolio.

Every mutual fund uses one of two strategies. A passive/index fund opts to track the holdings in a given index. For instance, the S&P 500 is the most popular U.S. stock index. An S&P 500 stock index fund will own the 500 stocks in that index. Period. No investment pro is sticking their neck out and deciding to own more of one stock and less of another. That’s where the “passive” comes from: Index investing is set it and forget it.

The other way a mutual fund can operate is to give the reins to an investment pro, who decides what stocks or bonds to own. When a human being is making investing decisions, this is referred to as “active” investing. Unlike passive investing that resolutely tracks a market index, active investing relies on the decisions of money managers.

Passive is more profitable.

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