Passive investing (or indexing) is a popular way to invest, as outlined in my earlier post. This is the first article of many in which I would like to explain in a simple way:
- what is passive investing/indexing
- why indexing can make sense and what returns are to be expected
- why sticking to your initial strategy is perhaps the most important thing
- how to start investing passively
- avoidable indexing pitfalls
- possible future risks for indexers
What is passive investing/indexing?
Passive investing is an opposite of active investing. Where active investors try to analyze companies, macroeconomic and political trends or employ quantitative models to provide better than market return, passive investor believes that sticking to a simple widely diversified (see diversification) portfolio.
It used to be the case that creating and maintaining a diversified portfolio was very expensive as each position (in a stock or a bond) had to be executed individually. However, nowadays investors can choose from thousands of exchange traded funds (ETFs) that hold such diversified portfolio for them at extremely low management fees ranging roughly from 0% (for certain most popular ETFs) up to 1% for the most complicated ones.
For example iShares MSCI world ETF (as iShares is by far the market leader in ETFs for Europe based investors) at the moment provides you with a portfolio compose of stocks listed in the following countries:
As a result, ETFs now provide a fairly high benchmark, tracking a widely diversified portfolio of even thousands of stocks across countries and sectors at very low costs. Why costs have a far higher impact on your long term investment results and what kind of returns can be expected will be discussed in the next article.