Index Investing Is Not Passive Investing. Here’s Why…

Many investors try very hard to portray themselves as cool and calm, unflappable in the face of market ups and downs.

They like to think of themselves as unwavering before the many pressures that can affect investment decisions: politics, economic news, disasters or bad earnings.

In short, they love the idea of being “passive” investors. Often, too, investors use the word passive as a synonym for index investing. After all, isn’t indexing the polar opposite of “active” investment management.

Yes and no. It’s important to understand the differences and to grasp why active, passive and indexing all have elements of each other, for better or worse.

Most “active” investors are pretty close to being indexers. They try to own the biggest companies in the market and they like the idea of sticking with a good company through thick and thin.

The classic “passive” investor, meanwhile, is best understood as a silent partner or, in some cases, as a real estate investor. For the passive investor, hands-on management is not the goal.

Rather, the goal is to own investments that generate income with as little effort as possible. This also tends to feed into the idea of staying in an investment for a long period of time.

Index investing, meanwhile, captures parts of each philosophy. The index investor wants to own quality companies in the stock market. Buying the index reinforces that idea.

After all, an index of the top 500 or 1,000 companies will be the biggest and most widely held companies. The work of selecting is no longer necessary.

Indexes change composition from time to time, too. Some companies drop off and others come on, changes that reflect the economy itself. Not a lot of people own railroads like they did in, say, the 1800s.

In the same way, nobody a few decades ago owned a stock anything like Facebook, Amazon or Google. Many huge companies today didn’t exist then.

However, the index investor doesn’t really look to change the world by making investment choices. He or she is content to own the growth and income of the whole market with very little concern over how the managements of each stock make company decisions.

Thus, effectively, indexing is a kind of passive investing, too. Being less concerned about the how and more about the how much is the hallmark of true passive investing.

Three-legged stool

It’s best to think of passive, indexing and active as three legs on a stool rather than as opposing forces. There likely will always be active traders out there trying to bid prices and up down and catch each other out.

The index investor doesn’t bother to keep track of all that, since trading is a zero-sum game. Yet index investing is not just passive investing. It’s as active as the market itself, since the index automatically selects winners and losers year in and year out.

The index investor collects the value while paying the lowest possible price for taking part in the investment process — a win-win if your goal is efficient, effective returns.

MarketRiders, Inc. is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.