5 Risks You'll Face From Passive Investing And How To Mitigate

There are many methods to achieve financial independence and among those is the time-tested strategy of passively investing into a well diversified, low-cost index fund.


What's not to love about this straightforward approach?


Just keep buying regularly with an amount of money that you won't miss for at least the next 5 years, give your investments time, and stay invested no matter what happens. It really couldn't get simpler.


Time and again you hear stories of how the passive investment approach will beat the vast majority of investors who try to pick individual stocks, or try to time the rise and fall of the markets. Even the greatest investors out there recommend that the average person should stick with the index since it's unlikely they will have an edge over the market average.


Just keep buying as the market will rise over the long term and through the magic of time and compounding you will have more money than you put in.


It's almost like you can't lose - and if you think about it, anybody who has adopted a buy and hold strategy since the start of the stock market arguably hasn't ever lost since the markets have never gone to zero.


So does that mean passive investing is completely free from risk?


Unfortunately, it doesn't.


During my time using this strategy I've had to overcome various trials and moments where my overall position has teetered between continued gains or huge setbacks.


But the important thing to note is that none of these were due to the market itself.


That's right - every risk I ever faced while passively investing has been a result of something outside of the market. Most notably myself, or someone trying to get me to do something that isn't "optimal" in the context of passive investing.


Humans are inherently fallible and in a strategy where doing less is more, the weakest link actually comes from ourselves.


In this article I wanted to cover 5 scenarios that I've faced during my investment journey so far to give a bit of insight into the kinds of risks that you might face if you adopt the passive strategy for yourself.



Identifying and mitigating risks is a key to success. In this example I was very focused on the motorbike game and may not have noticed something falling on my head. So I took precautions!
Identifying and mitigating risks is a key to success. In this example I was very focused on the motorbike game and may not have noticed something falling on my head. So I took precautions!


FOMO: Fear Of Missing Out


Bitcoin, Tesla, or even GameStop - when you start to participate in the investment world you're going to naturally find yourself exposed to people who take a more active approach by stock picking.


While the vast majority of people underperform the market - or simply lose money - you'll sometimes hear about an "investment" that has yielded fantastic returns in a really short amount of time.


"I bought in yesterday and I've already doubled my money!"


It's hard not to become a little interested when you hear such statements but always keep in mind that most people lose money in the markets over the long run when they jump on these hyped up opportunities.


Sure, sometimes they can get lucky and make a rather large profit over the course of a couple of days but I doubt anybody out there will actually make money consistently over a number of years by chasing the next hot thing.


What's the point of making big returns on one hot pick if you're constantly losing on the numerous others?


It's a bit like the casino where you usually lose £100 every month you go, but one month you'll happen to win £200. The high feels good at the time but if you really think about it, you haven't actually won anything since you're still negative overall.


Additionally you should keep in mind that you only really hear about the winners when they get lucky in the market, but you'll hardly hear from the losers. This is only going to skew your impression on how frequently you could win. For every winner you see there were probably thousands of losers.


If you really can't resist the temptation - we're all human after all - then at least exercise some restraint and only partake under the knowledge that you're likely to lose your money instead of winning.


You wouldn't bet your entire house in the casino, so don't do it on a FOMO bet in the stock market.


Keep your exposure to a minimal amount, like 5% (as an example) of your overall investment money, and leave the rest in the passive investing account. This at least means you have a solid foundation that ensures you won't get wiped out if the bet goes wrong.


If you lose, you lose - don't go chasing it.


Take the lesson and use it to build your experience and knowledge. You're not the first and you won't be the last to get caught up in a hype.


There's nothing wrong with paying for a bit of tuition in the market - but there's certainly a problem if you let it take you out of the game completely.


If that happened you'd then be really missing out, on the entire market.


Check it out: 3 mistakes I made as a trader and the lessons I learned



Feeling like you need to defend your actions - or inaction


Set and forget is often recommended when taking the passive investment approach. Just make sure that you're buying a tiny piece of the entire market regularly and don't look at it for a number of years.


The longer the better.


But every now and again you might enter into a conversation with other people, friends and family, about money matters. Perhaps a casual chat over a barbeque or something - nothing really serious.


While the others are bringing up what they're doing with their money:


"We're saving for a big holiday next year."


"We've been in our house for a number of years now, I think it's time to upgrade and change the scenery a bit."


"Oh we're just putting some of our money away for the rainy day fund."


You might mention:


"Actually I invest a part of my money into the financial markets."


Since most people aren't familiar with this (I guess it depends on your social circle) they might start to ask the typical questions: "How do you know what to buy?", "Isn't it like gambling?", "What if you lose all your money?"


At this point you'll start to explain your passive approach - you're actually not that involved with picking any single stock or industry and actually you're doing a whole load of nothing in particular, since you're really just waiting for time to work its magic on your returns.


To someone who doesn't really get involved with investing that's going to sound crazy - like you're telling them that you're going to drive a car blindfolded and as long as you put your foot down you'll eventually get to your destination.


The resulting warnings and unsolicited advice could make you feel like you need to work really hard to explain yourself, which can become really frustrating at times. The "advice" is well meant but you can't help but feel that the other person thinks you might be taking on some unreasonable financial risk.


At the end of the day you invest your money for yourself and nobody else, so it doesn't really matter if other people don't approve of what you're doing. People will often have all sorts of input and "advice" when it comes to what to do with money - and it's often shared honestly, with maybe a sprinkle of humble-bragging if they've done well for themselves.


But don't let yourself be easily swayed by the opinion of someone else - keep your mind open but also keep your conviction on the reasons for why you started passively investing in the first place.


After all, it's hard for them to understand that you're not the one who's actually driving - you're just a passenger of the market and waiting for it to continue rising upwards over time.


Check it out: Why does everyone recommend passive index funds and to avoid timing the market



Becoming impatient


Passive investing is somewhat the antithesis of becoming rich overnight. By choosing this strategy you're opting for the steady path that will surely get you to the finish line over a period of time, provided you stick to the plan.


You will get there eventually but it's likely to take a number of years, and it's easy to become impatient.


Due to impatience you might start to think about doing things that might help speed up the process. But typically the increased speed will come with additional risk, and usually more of the latter than the former.


An example is using leverage to try and maximise your exposure to the financial markets. Be it through magnifying your exposure or borrowing money in order to buy more of the market, leverage can be exceptionally dangerous.


Never forget that leverage can work against you just as it could work for you, and should the market go in the wrong direction you might find yourself unable to take the damage.


That would only result in you being completely out of the market with a very large hole in your wealth.


Remember that financial independence is a process and not a single event in your lifetime, so you don't need to rush yourself to the point where it becomes reckless. Slow and steady will win the race and a lot of the things you're hoping to be able to do after early retirement can actually already be done today, but with more moderation.


Once you realise that wealth is all around you and not entirely "locked" behind a financial barrier, you'll start to discover ways in which you can create an environment where you are actually enjoying your journey.


And when you start to enjoy your journey you'll realise that financial independence is simply a goal to aim for, but it isn't the requirement for your life to be happy.


Check it out: Why you don't want a money cheat code





Feeling like it's too simple


There's only really 3 steps to the passive investing strategy:


  1. Pick a low cost fund that tracks a diversified index.

  2. Invest a small amount of money into it regularly.

  3. Wait patiently.


So it's easy to start feeling like everything is a little too straightforward.


You might then start to wonder if you need to make things a little bit more "advanced" by diving into different types of assets or investment classes, just so you feel like you're actually doing something.


A common thing to start doing is creating a mix of funds - where you try to pick 3 or 4 options and invest a little into each to create a "balance" - to make yourself feel better, as though you've put a little bit of "real work" into your portfolio.


In reality all you're probably doing is giving yourself extra overhead and maybe even making your portfolio a little less balanced than it would've been with a single well-balanced low cost index fund.


If you did come up with some sort of mix, there are three possible outcomes:


  1. Your mix of funds has the same (or very similar) performance as the single fund.

  2. Your mix of funds underperforms the single fund.

  3. Your mix of funds outperforms the single fund.


In the first outcome you basically lose in terms of time and effort. You might have the same returns but you would've spent more of your personal time finding and balancing your mix of funds. Therefore this isn't a good result.


The second outcome is bad for obvious reasons. You'll probably be really annoyed at yourself if this happens because you'll have lost both money and time and wished you simply kept things simple from the start.


The third outcome only happens through luck, rather than any "great pick". Think about it - if the single fund tracks the market then the only way for your mix of funds to beat it is to be skewed in some way towards a sector or a region that is doing well. This has nothing to do with you finding some "magic balance" and is really just down to being lucky.


The real test comes after more time in the market, perhaps after a crash, to see if your mix continues to perform better or if it gets brought back into line with the rest of the market.


In all honesty if you're going with a set of funds that are all diversified and balanced in their own right then the likelihood is that you're probably going to do alright in the long run. Everyone makes money in a bull market at the end of the day.


But remind yourself why you ended up choosing the passive investing strategy in the first place: It was low maintenance.


So let it be exactly that.


Don't psych yourself out by thinking things are too simple because the "extra work" you end up doing, like I described above, is often for naught - because you don't even know what the market will do in the future anyways.


As long as you've picked a well diversified passive fund that includes a wide variety of companies from different regions and sectors, plus also includes some different asset classes (equities, bonds, commodities etc), you honestly don't need to do too much more.


Check it out: 5 Do's and Don'ts For Every New Investor



Getting Complacent


I've mentioned a few times in this article that you should simply leave your investments and not touch it for as long as possible. The longer the better.


This is because compounding requires time to really get going and the longer it goes on, the more powerful it becomes.


But the thing I don't want you to do is become complacent.


Financial independence requires more than just passively investing into an index fund, it requires good management of your personal finances in other areas of your life.


If you don't have those other areas under control then you could be damaging your progress overall, and in fact never reach financial independence at all. For example 10% returns from your investment portfolio sounds great, but not if you're paying away 20% of your wealth towards debts.


Budgeting, paying down debt, having an emergency fund, increasing your savings rate, using tax advantaged accounts are all things outside of investing that you should be staying on top of to ensure that your financial foundations are really healthy and able to support your wealth into the future.


Another reason why you want to have a solid financial foundation is so that it can help you weather any storms in the financial markets.


Passive investing is a marathon that will take you deep into your more advanced years, which hopefully means a number of decades. This ultimately means you are going to need to survive a big market crash, and possibly more than just one.


There's no point hoping it won't happen in your lifetime because that would be somewhat irrational. Almost as irrational as worrying about the market going all the way down to zero.


If your financial foundations are shaky when this happens then the chances are you're more likely to be less confident in your ability to get through it. Imagine seeing your investments decline in value by something like 50% when you still have big debts to pay or if you were made redundant and didn't have the financial buffer to last the next few months.


Under such circumstances you are likely going to want to - and probably will - get out of the market to preserve what's left of your money. After all, you can't afford to lose anymore because you might need to use it to cover your immediate financial problems.


Getting out of the market will mean you crystallise your loss and will not be able to benefit from the recovery that has always followed a crash.


While it might have been "unavoidable" due to the circumstances you were in at the time, it is also hard to say you couldn't have done more to prepare yourself.


Never forget that passive investing is only one slice of the journey towards financial independence, and that the ability to allow it play out in full over the long run still requires you to be active and involved in the other financial aspects of your life.


Check it out: 6 pillars of wealth



To Conclude


It's easy for us to become trapped in an echo chamber with our contemporaries from the passive investment club and encourage each other with the same old positives and benefits of the strategy - I'm certainly guilty of such practices because deep down I truly believe in it.


But as much as I'd love to say "keep calm and cost average" I have had some moments throughout my journey where the risks have been very real.


And the worrying thing is that I don't recall ever coming across any material about this side of passive investing.


Sure, if I go and search for it there'll be something but not a whole lot, and none of it has ever naturally entered my own conversations.


I guess it's partly to do with my own search or conversation tendencies and also the fact that a simple passive investing approach doesn't have much risk in the "system" itself. But there's always a human side to consider and that's where the weak link is found.


In writing this article I hope to provide that "other side" and give you a little bit of food for thought based on my own experiences. As long as you're preparing for the risks well ahead of time you can always be confident in the knowledge that you've done what you can.


And with that reassurance you can then truly keep calm and cost average.



Hey - just one final word before wrapping up - Regardless of the investment strategy you're considering there is always a bit of a psychological barrier to overcome for anyone who has never made an investment before. I myself have written a few times about overcoming these but I found a really nice short article by The Twenty Percent that can help you see past some of the most common misconceptions.


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My mission is to help people understand their money by making financial scenarios or concepts easy to understand. Support me by sharing the blog with someone that you want to help.

Thanks for reading!

Kujah

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