Why It Might Make More Sense to Do Nothing With Your Money: The Pros and Cons of Passive Investing

Hey Bank of Dad, what are some of the best ways to be hands-off with my investments? Passive investing — or passive management — is a strategy, but is it a smart one? Is there a case to be made for it? Is there something horribly wrong about this approach? Basically, what do I need to know about passive investing? — Stan, 41, New York

You’re certainly not alone in that department. Everyone wants their retirement account to grow nice and fat so they can kick their feet up while they’re still in good health. That doesn’t necessarily mean you want to spend your time pouring over earnings reports or dissecting the latest speech by the Fed chairman in the hopes of juicing your returns.

Truth be told, there’s ample evidence that a more hands-off approach actually results in better performance much of the time. Tinkering too much with investments can do more harm than good, causing you to rack up transaction fees and capital gains taxes — not to mention throwing your portfolio out of whack.

When you mention “passive” investing, you could be talking about one of two things. There’s being passive when it comes to selecting stocks and bonds. In a sense, all mutual funds fit that category in that the investor isn’t hand-picking what securities they own. However, the term is typically applied to index funds and exchange-traded funds (ETFs) that simply mirror an index – say, the S&P 500 (huge companies) or Russell 2000 (slightly smaller companies).

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Passive funds actually eclipsed actively managed funds in market share last year, and for good reason. As they offer lower fees, index funds and ETFs beat their peers most of the time. In fact, over the past ten years, only 23 percent of traditional mutual funds were able to beat their passive rivals in terms of net returns, according to the research firm Morningstar (though the advantage is less clear with bond and foreign stock funds).

But you can also be passive when it comes to investment management – that is, choosing which funds to buy and calibrating your overall asset mix (U.S. stocks vs. international stocks, corporate bonds vs. government bonds, etc.). One way to do that is with a target-date fund, which typically invests in a mix of index funds or ETFs.

There are some distinct benefits to this approach. For one, they’re highly diversified. They may own shares in dozens, or even hundreds of firms, so you’re well-insulated from any one company falling on hard times.

These products are basically on auto-pilot – gradually steering the portfolio towards a greater percentage of corporate bonds and Treasuries as they approach the chosen retirement date. Because of this, they help prevent you from taking on too much risk as they get older. When you compare them to traditional investment managers, they’re pretty affordable, too. The average expense ratio for target-date funds is around 0.5 percent a year, although a number of fund companies go quite a bit lower. For instance, the 2050 target-date fund from Vanguard, the pioneer of passive investing, is a paltry 0.15 percent. Fidelity’s 2050 fund charges even less: 0.12 percent.

As of last year, more than half of workers put all of their 401(k) money into a target-date fund, based on data from Fidelity. It doesn’t mean they’re perfect, by any means. Every investor who chooses a particular retirement date gets the same portfolio, regardless of their account balance or goals. But as a basic answer for novice investors who are happy with a “buy and hold” strategy, it’ll keep you from doing anything silly with your nest egg.

Over the past few years, we’ve also seen the explosion of robo advisors like Betterment and Personal Capital that offer a slightly different passive-investing tack. They, too, manage your investments for you, but there’s a bit more customization involved. You’re asked a series of questions about your financial situation and long-term goals when you open an account. The service then uses an algorithm to devise a mix of assets – typically low-cost instruments – that meets your needs.

No two robo advisors are exactly alike, but they tend to differ from target-date funds in a few important ways. Because there’s greater personalization, they can make changes based on your specific circumstances. For example, some offer tax-loss harvesting, where they sell certain funds for a loss in order to offset a portion gains for the year, thereby reducing your tax bill.

Some also offer access to real-life financial planners (sometimes as part of a high-tier plan), should you need a little hand-holding before making an important decision. As you might imagine, you usually pay more than you would by choosing funds on your own. But most are cheaper than hiring a wealth management firm. Wealthfront and Betterment both charge 0.25 percent on top of their low fund expenses (though Betterment has a higher tier that costs 0.4 percent). Personal Capital is at the higher end of the spectrum, charging customers 0.89 percent for accounts that total less than $1 million.

The takeaway is this: it never hurts to know what you’re investing in and how financial products work. But you can be passive without being aloof. Because even most professionals aren’t good enough to beat the market consistently, most folks are actually better off more of a “buy and hold” approach. If you want to get really hands-off, target-date funds and robo advisors can help rebalance your assets and, most importantly, ensure you’re not doing anything foolish. Isn’t that what we all want anyway?