Passive investing is an approach to investing that avoids trading intended to enhance returns. It is the opposite of active investing.
Passive investing has the advantage of low cost. Depending on the style used, it entails only modest or no investment management fees. It avoids most of the transaction costs associated with active investing. If a portfolio is taxable, capital gains can be deferred for years or even decades.
There is nothing new about passive investing. Since the development of securities markets during the 17th century, wealthy families bought and held bonds to maturity, clipping the coupons for income. Active trading of securities was, more often than not, considered the realm of speculators and confidence men.
Attitudes changed—in fits and starts—during the 20th century. A number of factors increased participation in securities markets, including
- Wall Street’s embrace of modern marketing techniques,
- high long-term stock market returns, at least in Western democracies,
- new regulatory frameworks, which gave investors more confidence participating in securities markets, and
- the emergence of pension funds and other institutional investors.
Responding to—and also contributing to—this trend, investment advice became increasingly professionalized. Banks and brokers—especially Merrill Lynch—developed large networks of stockbrokers. Investment advisors and consultants proliferated. To maintain an ongoing need for their services, these professionals embraced active investing for their clients.
Empirical studies of the performance of active investing date to Cowles (1933), but work accelerated during the 1960s, especially with Fama (1965). Results were consistently dismal, leading to Fama’s (1970) efficient markets hypothesis. A distinction between active investing and passive investing crystallized in investors’ minds. Many sought out and adopted styles of passive investing suitable for their needs. Two styles of passive investing are widely used today:
- Cowles, Alfred 3rd (1933). Can stock market forecasters forecast? Econometrica, 1 (3), 309-324.
- Fama, Eugene F. (1965a). The behavior of stock market prices, Journal of Business, 38 (1), 34-105.
- Fama, Eugene F. (1970). Efficient capital markets: A review of theory and empirical work, Journal of Finance, 25 (2), 383-417.