What Is Passive Indexing?

Investing in the stock market might seem like a thrilling, high-octane race, but there are ways to enjoy the ride without sudden twists and unexpected turns. Arguably the safest of all possible strategies is passive indexing -- the tortoise in the investment race that often outperforms the unpredictable hares in the long run. Here's what this slow-and-steady strategy is all about and why you should know the basics.

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Passive indexing is an investment strategy where the investor mirrors a particular market index. For example, you can match the elite 30 stocks of the Dow Jones Industrial Average (^DJI +0.56%), the broader stock market barometer of the S&P 500 (^GSPC +1.29%), or the tech-heavy Nasdaq Composite (^IXIC +2.00%), pick an appropriate fund or exchange-traded fund (ETF) that does the hard work on your behalf, and let it ride for years.

Rather than trying to beat the market, investors in passive index funds aim to replicate its performance. Think of it as the financial equivalent of playing it cool at a dance-off; you're not trying to outshine anyone, just keeping in step with your chosen market index.

Whether you're leaning on a traditional equity fund such as the Vanguard 500 Index Fund Admiral Shares (VFIAX +0.14%) or its ETF sibling -- the Vanguard S&P 500 ETF (VOO +1.31%) -- the fund managers will buy, sell, and manage stock option holdings and more to match the index fund's performance as closely as possible.

The best of these funds are highly automated, resulting in very precise index-tracking results and low management fees. All you have to do is hold on to a single fund, adding more cash or taking funds out as required, and enjoy the benefits of effectively owning dozens, hundreds, or even thousands of individual stocks. It's instant diversification, long-term stability, and the freedom of picking your favorite market index -- all rolled into one.

Why passive indexing matters

Passive indexing is not merely an investment buzzword; it's a significant way that many investors build their portfolios. Here's why it's worth a second look:

Low costs: Passive indexing generally involves lower management fees since it doesn't require the constant oversight and active decision-making typical of active management strategies. In other words, you don't have to pay the fund manager to do any market research for you.
Less risky: By mirroring the results of a large industry or the entire market, you're not putting all your eggs in one corporate basket. Diversification for the win!
Tax efficiency: Index funds generally operate with a long-term buy-and-hold approach, rebalancing their holdings only when the underlying index adds or removes tickers. As a result, the funds dodge the capital gains taxes that result from making frequent trades.
Historical success: Passive index funds often perform as well as or better than actively managed funds. Call it the "slow-cooker" method of investing -- it may not sizzle and pop on Wall Street's proverbial back burner, but it is likely to satisfy your wealth-building appetite in the long run.

Buy & Hold Strategy

A buy-and-hold strategy in investing entails buying stocks or other securities and not selling them for long periods of time, sometimes decades.

How to utilize passive indexing

Now that you've had a glimpse into the world of passive indexing, what should you do about it?

Investigate your options: Look into passive index funds that suit your investment goals. You could go for ultimate stability with broad market-tracking indexes. You could pinpoint a specific niche by selecting a more narrowly defined index. Passive index funds can even help you target opportunities abroad, tracking foreign lists such as the broad-based MSCI Japan or the MSCI Europe indexes.
Consider the risks and rewards: Passive index funds are known for stability, but make sure they align with your risk tolerance. For example, the Nasdaq Composite Index tends to experience more short-term volatility than the S&P 500. Nasdaq gives you a wobbly path to potentially larger gains over many years, while the S&P 500 offers more stability in an unsettled economy. That key difference should steer you toward the index that meets your needs.

Meet Jack Bogle -- the godfather of passive indexing

Vanguard Group is not the only name in the low-cost index fund game, but the firm is a leading provider of passive indexing tools -- and a pioneer of the passive investing idea.

Founder John "Jack" Bogle essentially created passive index investing with the launch of the First Index Investment Trust in 1976. The fund, now known as Vanguard 500 Index Fund Admiral Shares, tracked the S&P 500 with a hands-off management approach, resulting in the low fees and high tax efficiency mentioned above.

Bogle's work was largely scorned by the financial industry at the time, but Bogle's game-changing approach has proven successful in the long run. Nowadays, even master investors like Warren Buffett celebrate Jack Bogle's positive impact on individual investors.

With a passive indexing portfolio, you don't have to be a masterful stock picker to match the long-term gains of the stock market.

About the Author

Anders Bylund is a contributing Motley Fool media and technology analyst covering semiconductors, cloud computing, internet infrastructure, quantum computing, and streaming media. Previously, Anders was a systems administrator for Nielsen Technology and CSX, gaining hands-on experience with enterprise-class systems. He was also a freelance writer for Ars Technica, TIME, USA Today, CNN, WIRED, and AOL's Daily Finance. He holds a bachelor’s degree in English and a master’s degree in library and information sciences from Florida State University. He believes in coyotes and time as an abstract.

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Anders Bylund has positions in Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.