Just like its name indicates, passive trading is rather chilled out. That means that investors do not need to maintain a frenzied (or even calmly constant) watch on the stock market and news that affects it. Passive trading looks to track the stock market’s own growth in order to bring home earnings to the investor.
You can compare active traders to those out-of-the-box directors who make unusual films and entertainment series. They could sometimes break all records and become the most viewed and most talked about thing. Passive traders might be compared to directors who follow a cookie-cutter approach; who follow trends related to viewership and popular story concepts and formats. As a result, it is very likely that they will come up with content that beats all popularity and viewership records, but by playing it safe and following the trend, they can be sure that there will be takers for their content. They also have an easier job than their counterparts who choose to be out-of-the-box directors.
So it is with passive traders – they will fairly often track a stock market index (more on that in a few seconds) and although there might be no way for them to best the market’s performance, they can type at least expect low risk and some amount of dependable growth in their investment. This type of investing is easier because the trader does not need to be hyper-aware of news and hyper-vigilant about stock prices.
What is passive trading?
Passive trading involves buying stock market securities and holding them for a long period to benefit from long-term growth and the fact that volatility tends to plateau out in the long term.
A passive trader might choose to track an index, like the Nifty 50 for instance wherein he:
1. Purchases shares of companies in the same proportion that they exist on the related index
2. Purchases Exchange Traded Funds which are ready made funds that track a given index
Alternatively, a passive trader might simply do his research and pick out a good stock to invest in (as per his research on company financials) and will hold the stock for over one year, sometimes for several years at a time. Depending on who you talk to, some people refer to passive investing as mid-way ground between day trading and long-term investing. Others equate it to long-term investing. We’re going to go along with the latter and look at passive investing as a medium to a long-term mode of investing.
Passive trading’s meaning and essence is rooted in the following key fundamentals
1. Lower fees and charges, commissions, and brokerage related to less action. All of these come out of your earnings (or add to losses) and as such lowering them could mean higher earnings.
2. Lower requirement for expertise in using technical analysis to formulate strategies and make informed predictions.
3. Less involvement in terms of checking news and stock pricing to make constant trades. You can keep your regular job and conduct passive trading without neglecting either one.
How it works
A trader might buy a stock, set a target price and a stop loss and then forget about it. When the target price is reached, they take home their earnings. A better alternative may be to keep a check – as regularly as your job and other commitments allow you to – on the specific stock’s price and on the overall market to sell when the price is high.
Traders need to practice some amount of due diligence when choosing stocks if they intend to be passive investors. They should go through the financials of companies to check their viability and profitability potential in the long term. They might also want to use Warren Buffet’s favourite concept – Price: Earnings Ratio, or PE ratio – to choose stocks trading ‘at a discount’.
Upside and downside of passive trading
- Upside: Lower cost of investment
By simply buying and holding stocks, the trader avoids additional costs associated with multiple transactions. This lowers his cost of investment and contributes to increased profitability potential.
- Upside: Lower risk.
Especially if one has invested in stocks listed in an index, or if the trader has invested after thorough research on the company’s financial health and growth potential, he lowers his risk because most index-listed companies can be expected to deliver growth over the long term, even if stock prices display volatility in the short term.
- Downside: Lower chances of beating the market
Especially if you are tracking indices but also if you simply buy and hold stocks based on your own research, not watching the market and not capitalising on dips and spikes means that you cannot generate alpha or a level of profitability that beats the market. That said, you do have the chance of earning at the same pace as the market’s growth or the tracked index’s growth.
- Downside: Loss of liquidity
As the trader waits for slow and steady growth, his capital is tied in. If the stock price has not reached its target price – or has dropped – in the interim, the trader will want to hold onto his investment until the target price is reached.
Any type of trading – active or passive – comes with its share of risks. Always understand your risk appetite before investing.
Safe investing calls for always setting a stop loss, investing with capital that is left over after you have kept sufficient aside for the lifestyle you are habituated to, conducting sufficient research and avoiding emotional decision-making arising from fear or greed. Risk must also be minimised by portfolio diversification and what you’re already doing right now: getting educated.