InvestorQ : What is a passive investment approach to investing and what are the unique benefits of the same?
Katherine Gonsalves made post

What is a passive investment approach to investing and what are the unique benefits of the same?

Rutuja Nigam answered.
2 years ago

Passive investing entails mirroring a benchmark like the index and not worrying about timing the market or about stock selection. Globally, trillions of dollars are invested in passive fund and passive strategies, although that is still to take off in India in a big way.

Let us look at some of the very important and practical benefits of passive investing…

· The biggest advantage of passive investing pertains to cost. On an average, the cost of an index fund is less than 1/4th of a diversified equity fund. That is because fund management costs and transaction fees are much lower in an index fund. In fact, in the 2016 annual letter to shareholders, Warren Buffett had specifically commended the contribution of Sir John Bogle of Vanguard for saving billions of dollars for small investors in the US through his index funds. In fact, Vanguard is one of the largest index fund managers in the world and is estimated to have saved nearly $1 trillion for mutual fund holders in the US over the years. Cost-wise, passive investment strategies are very cost effective in the long run.

· Secondly, passive investing helps you to diversify your risk. An index like the Nifty or the Sensex is automatically a diversified portfolio since it includes stocks from all sectors and themes. When fund managers try to create a diversified portfolio, they run the risk of either over-diversifying or under-diversifying. Diversification reduces concentration risk in a portfolio and that can be achieved through passive investing.

· Passive investing helps you to reduce the transaction costs as the portfolio will be churned less often. As a result it also reduces the incidence of taxes. If you buy and sell stocks within a period of 1 year then it will result in short term capital gains tax and will be levied at 15%. However, indexing automatically compels you to take a long term view and hence becomes more tax efficient. Also, more number of transactions means that greater amount of Securities Transaction Tax (STT) will have to be paid.

· Lastly, investing is all about long term and hence calls for discipline. Passive investing automatically instils a degree of discipline into investing.