Passive and dividend investing could be a relatively hands-off way of gaining exposure to the stock market. Discover what passive investing is, how dividends work, and learn how to implement passive investment strategies in your portfolio.
Investing in the stock market does not have to be time-consuming. Passive and dividend strategies are potentially good options for those looking to gain exposure to the market and achieve positive financial returns, all while avoiding the need for hours of extensive research and portfolio management.
Although there are positives and negatives regarding passive and dividend strategies, they remain popular with many investors.
What is passive investing?
Passive investing involves a minimal amount of buying and selling. Investors that adopt this approach tend to favor instruments such as stocks and indices, which closely mirror the performance of the wider stock market.
Passive investors tend to adopt a buy-and-hold approach with the aim of making long-term gains. Stocks have historically produced inflation-beating returns, which is why some investors look to leverage them as part of a passive investment strategy.
Through the past thirty years more than two-thirds of professional portfolio managers have been outperformed by the unmanaged S&P 500 Index.
Burton Malkiel
What are dividend yields?
Dividend yields represent a company’s dividend payments, expressed as a percentage of its current share price. When a company’s dividend per share (DPS) rises or its share price declines, the dividend yield increases, and vice versa. Dividend yields are a simple metric that play a crucial role in any dividend investing strategy.
- Dividend yield = dividend per share in cash terms/share price
Tip: Dividend yields are a financial ratio that indicate the potential future income stream from a company’s stock.
Dividends tend to be paid to shareholders on a quarterly basis, although some companies choose to pay them monthly or annually. Financial calendars can be used to see the expected date of a dividend payment.
How to incorporate passive investing into your portfolio
Setting up a passive investment portfolio can involve as little as buying the S&P 500 Index, which comprises the 500 largest firms listed on US stock exchanges, such as Microsoft and Procter & Gamble. Given the multinational nature of many S&P 500 stocks, some investors utilize this index to gain exposure to the global stock market.
To further facilitate passive investing, fund-style products, such as exchange-traded funds (ETFs), have been created to offer a cost-effective way of passively investing in a range of assets and sectors, including bonds.
Passive investing strategies
Individuals with a longer investment time horizon are often more interested in passive investments than those looking for short-term results. Data suggests that stock markets tend to increase in value over time, although passive investors need to avoid becoming forced sellers during the natural troughs of economic and stock market cycles.
Returns on passive strategies can be improved when there is flexibility in the investment maturity timeline. Providing investments with more time to grow allows them to take advantage of market upswings, thus optimizing overall performance.
Hedging passive investment strategies
Market risk is one of the primary concerns for passive investors. Market risk refers to the possibility that the price of a held asset may decrease. This is an unavoidable part of investing that could potentially be mitigated by ensuring that your strategy allows enough time to ride out market dips, although there are other ways of hedging against this risk.
Options
Options are financial instruments that grant the holder the right – but not the obligation – to buy or sell an underlying asset at a future date. Investors pay premiums to buy options, which are quite similar to insurance premiums paid on everyday assets such as a house or car.
If prices go up and market risk is avoided, the returns on your passive income will hopefully offset the cost of buying options that you ultimately did not exercise.
VIX Index
The VIX Index, also known as the ‘greed and fear’ index, measures financial market volatility. It tends to go up during periods of uncertainty, which is typically when common passive portfolio investments decline in price.
VIX Futures can be bought and sold just like any other financial instrument. By acquiring a position in the VIX, investors can mitigate the impact of market downturns and provide a level of protection for their passive investments. This can be viewed as a hedge against a potential broader market correction.
Defensive assets
Certain assets tend to perform relatively well when the rest of the stock market is in a downward spiral. While they may not excel during a bull market, they serve as a hedge against broader market slumps.
Including defensive stocks, such as those found in the healthcare sector, or safe-haven assets, such as gold, in your portfolio can reduce overall losses when other stocks fall in value.
Advantages of passive investing
There are several good reasons behind the increasing popularity of passive investing:
- Built-in diversification: Buying a stock index or sector ETF allows you to buy a basket of different assets at the same time.
- Convenience: Funds are priced in real time. You can buy and sell an ETF position at any time the exchange is open.
- Cost: Low management fees and an avoidance of “over-trading” can result in lower trading costs.
Disadvantages of passive investing
Market risk is an inherent aspect of all forms of trading. Whether you adopt a passive or active approach, there is always a risk that the value of your investment could decrease.
When comparing passive investing to active investing, the major disadvantage lies in opportunity cost. While passive strategies offer a simpler and less time-consuming approach, there is always a possibility that dedicating time to “stock-picking” could potentially yield higher returns on your capital.
Tip: Passive funds managing US stocks are projected to surpass the size of actively managed funds by 2026.
Final thoughts
Passive investing involves investors trying to track the market rather than beat it. This could be a good option for those looking for a convenient, cost-effective way of maximizing the potential of their investments.
Even active traders can find value in allocating a portion of their capital to passive investment strategies. For example, when a trader has not identified a specific stock they believe will outperform the market, a passive fund may represent a better option than holding their wealth in cash.
Visit the eToro Academy to learn more about passive and dividend strategies.
FAQs
- When is the best time to start passive investing?
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Passive investing involves tracking the market, and so the best option for starting to invest is “buying the dip”. This will help to improve your returns, but timing the market is incredibly difficult. Alternatively, setting up a regular investment scheme, perhaps with monthly, quarterly or yearly investments, will help to average out your long-term trade entry price.
- How reliable are dividend forecasts?
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Certain companies, such as Shell, have a track record of paying dividends to investors. Any significant shift in this approach would likely face strong criticism from existing shareholders. Although future dividends are never guaranteed, the longstanding dividend payment history and the interests of key stakeholders are usually enough to discourage abrupt changes to dividend policies.
- Why is passive investing increasingly popular?
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Not everyone aspires to be a stock picker, and even those who do may lack the required skill set to be good at it. Passive investing offers a convenient and cost-effective way to follow a different approach with the intention of making long-term returns.
This communication is for information and education purposes only and should not be taken as investment advice, a personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments.
This material has been prepared without taking into account any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
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