Passive investments, also known as a buy-and-hold strategy, are a common investment method. And while the strategy has many advantages, many investors are unaware of the risks of passive investing.
According to Investopedia, the goal of passive investment is to build wealth gradually. To do this, investors buy index funds and stocks and hold on to them for a long period of time. By avoiding the quick buy and sell strategy, investors reduce fees and complications that often come with very active portfolios.
While this all sounds promising, passive investments aren’t for everybody. Here are the three biggest risks of passive investing.
1. Smaller potential returns
Active investments, where investors buy and sell regularly, pose higher risks, but they can also bring greater financial rewards. A big risk of passive investing is that it might never bring in massive returns. This is because passive portfolios tend to follow a specific index, rather than individual stocks which are more likely to fluctuate and offer a better chance for profit during a quick sale.
Active investors can take advantage of short sales if their individual stocks become risky. Passive investors, on the other hand, are less likely to focus on single stocks and instead favour exchange-traded funds (ETFs) or index funds. Because EFTs hold many assets from different companies, it’s harder to time when to sell them.
2. Low cost doesn’t always mean low risk
The low cost of passive investing makes it attractive to many stockholders. As passive investors usually don’t track the market and just hold on to their passive stocks and funds for a long time after buying, market fluctuations are often ignored. Simply put, even if there’s a market dive because of a recession, passive investors believe the market will eventually recover and that they can hold on to their portfolio until that happens. As a result, they don’t have additional costs, such as fees or yearly capital gains tax.
This doesn’t mean that passive investments are always low risk. Market volatility can still affect them. In addition, passive investments often create a false sense of security. As a result, passive investors are less likely to check their portfolio or deal with asset relocation regularly.
The problem is, portfolios don’t manage themselves. And while passive investments require less work than active investments, investors should still pay attention to their assets and change their investments when necessary.
3. Holding on too long
Passive investments are meant to be long-term investments. But inflation, economic market crises, and the highs and lows of the market should still be carefully considered. To lower the risks of passive investing, stockholders should still have an exit strategy in mind.
Because they never know when market fluctuations are going to happen, they need to decide in advance what their goal is. Either they will stay in the market until they can exit on a high, or they plan to cash out after a set period of time, regardless of where the market is at the time. Investing emotionally without a plan can wreak havoc in a portfolio. If passive investors end up selling in a panic, they’re bound to make mistakes.