Passive or active investing: why passive might be the best for you to start with

Before you can start investing, there are some crucial choices you need to make.

Today, we’ll talk about a tough one, which is a long-standing debate in the world of investing:

Is it better to invest actively, or passively?

Before you can answer that question, it’s probably a good idea to understand what those terms mean in the first place.

Active Investing

In active investing, you research individual companies and buy and sell stocks in an attempt to beat the stock market.

I usually describe active investing as “having an opinion about which companies you think will do better and buying those”.

Passive Investing

In passive investing, you buy a basket of assets and try to mirror what the stock market is doing.

If active investing is like having an opinion, passive investing is not having one!

And that’s not per se a bad thing; if you’re not sure which stocks will do better than others, why not buy a lot of them, nicely spread out?

Good idea, but how do you do that?

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Indices (singular: index).

What’s (in) an index?

Maybe you’ve heard the words “S&P 500”, “NASDAQ”, or “Dow Jones” before.

They are pretty famous indices in the U.S.

But what’s an index?

An index is a (large) group of individual stocks clustered together.

Usually based on some metric.

For example, the NASDAQ, which is a collection of U.S. tech companies.

The Dow Jones contains 30 prominent companies (the U.S. too).

Closer to home, we have the AEX (large companies in The Netherlands) or the EU50 (the name says it all).

There are literally thousands of different indices.

So why should you care about them?

Why do indices exist?

The news reports heavily on these indices whenever the stock market makes headlines (often when there are crashes).

You’ll hear stuff like “Dow drops 600 points, Nasdaq closes 3% lower as …”.

The news reports on these indices because they are used as a proxy for how well the market is doing.

And to some extend, the economy. But not always! The stock market can be up while the economy is sh*t (see COVID times).

To know why indices are a good proxy, we have to understand how an index works.

There are different ways to construct an index, but most often, it is done by ‘size’ (to be more precise, by market capitalization) or by sector.

The S&P 500 is an index consisting of the 500’ largest’ (publicly traded) companies in the U.S.

This seems to be a good proxy for the U.S. economy, as they account for about 75% of GDP.

GDP stands for Gross Domestic Product, the total value of all goods and services a country produces in a year.

Besides being helpful to see how well the economy / a group of companies is doing, an index is also a great way to get investing exposure to many companies! A broadly diversified way, if you will.

The only issue, though, is that you can’t actually buy an index directly.

So, do it yourself?

You might think: “Well if I know which companies are in an index, I can just buy them all myself, right?”.

In theory, this is true, but there are some complications.

When buying individual stocks, you often have a minimum purchase of one entire stock each time.

So you can’t always simply buy 0,75 stock of Tesla ($TSLA), for example.

At the time of writing, one Tesla share goes for $223,07.

If you tried to recreate the S&P500 in your portfolio by yourself, you’d have to buy all 500 companies to the ratio of how they are in the index.

This would require a large starting sum to invest with, and it would be quite a hassle to do (and maintain).

And all these transactions will cost money (a fee) too!

Not ideal if you’d like to invest, say, €200 a month.

The best trackers in town

That’s why some smart guys and girls at some point created index trackers.

These investment products try to mimic an existing index as closely as possible.

Great!

Now, let’s add one last innovation and abbreviation into the mix: ETF.

ETF stands for Exchange Traded Fund.

ETF refers to the structure of an investment fund, stating that, as the name suggests, it is tradable on an exchange.

That means ETFs can be bought in fractions (so not full ‘units’) and bought and sold throughout the day.

Unlike traditional investment funds (mutual funds), you can only buy or sell once a day (or less).

ETFs are typically relatively cheap in terms of the costs you pay (management fee, broker commissions and so on).

Combining all that we’ve learned

So, passive investing is about not making a choice for any one particular stock.

Instead, you’re opting to purchase a broad basket of many stocks that represent the market.

Indices are good indicators of the general market performance. But we can’t buy them directly.

That’s why index-tracking products exist. Combined with an ETF structure, we can get cheap, broad exposure to the entire market!

Some examples of popular ETFs are:

• SPY (the first ETF, tracks the S&P 500)

• IVV & VOO (by iShares and Vanguard, respectively, also track the S&P 500)

• QQQ (Invesco QQQ Trust, follows the NASDAQ)

As you can see, stocks and ETFs often have abbreviations, so it’s easy to find them!

Furthermore, you can think of basically any type of investment style, asset class or theme and find an ETF for it.

Think: 🏆️ gold, 🔐 bitcoin, 🏬 real estate and ‘💎 value investing’ or ‘📈 growth investing’ or thematic stuff like '⚡️️ energy' and '🏥 health care'.

We’ll talk about all of that later 😉

A nice website for comparing ETFs is etfdb.com. Here you can see the largest ETFs. But keep in mind size isn’t always the most important thing.

Passive investing a great way to start for the beginning investor.

I personally have about 70 or 80% of my portfolio in either passive products or broadly spread holding companies.

Still, there are many reasons why active investing has a nice role to play too, which we’ll talk about next week 🤓