PASSIVE INVESTING

Why invest?

The main reason why we would want to invest, instead of just stuffing banknotes inside our mattress for insulation, is to combat the erosive effects of inflation.

Investments can take many forms from those known as "cash", through equities, bonds, and even exotics like derivatives. We will cover some of these under asset allocation.

Active vs Passive investing

There are many ways to invest. Here we will be looking at two opposing investment styles, active vs passive investing.

What is active investing?

You may be familiar with active investing from Hollywood movies. Active investing is when someone actively buys/sells shares, or other investments, themselves trying to "beat the market" on some hunch. Professional active investors wouldn't dream of doing this on a "hunch", so they invest incredible amounts of effort into researching what investments/companies they think may do better in the market at any given time. There are numerous active investment strategies, which we won't go into here, but the main takeaway is that active investment, done properly, takes effort. Lots of it!

Active investing is a zero-sum game: where one active investor wants to buy a stock, another must have to want to sell it. This means that, amongst active investors, where one "wins", the other one "loses".

Another thing to bear in mind is that buying/selling stocks tends to incur transaction costs (though this appears to be changing). So the more you actively invest, the more you are also losing to transaction fees, rather than investment returns.

Human psychology can play many tricks on the mind of the investor. For these reasons and more, active investing is not recommended for anyone but the most dedicated investor.

What is passive investing?

Passive investing is an investment strategy that aims to maximise returns by minimising buying and selling. The main form of passive investing is index investing: investing in order to replicate a market index. Though one could attempt to replicate a market index themselves, this is impractical on many levels, so the main way to invest in an index is to invest in an index fund that replicates your index of choice, or, these days, an ETF that does the same thing.

The main benefits of passive investing come from long time horizons and applying the power of compound interest, i.e. reinvesting your gains back into your investment portfolio.

Comparing active vs passive investing

Compound interest/returns

TODO: insert short description of compound interest.

Compound interest is about reinvesting the interest earned. Therefore, be aware of different types of funds:

• accumulation funds, which automatically reinvest returns back into the fund, without user intervention.
• income funds, which pay returns back to the investor, and it is up to the investor to re-invest those returns back into the fund themselves.

The effects of costs/fees

Costs and fees should be seen through the lens of compound interest. Whereas a 2% fund management fee may seem small, when considering the effects of compounding, this can have a big effect on your total return.

Other costs to consider are taxes and trading costs. If your platform charges you every time you want to buy or sell an investment, you should really look to minimise the number of times you do this a year.

Psychological pitfalls when investing

It is said that the biggest danger in investing is the investor. This is because we are constantly fighting unconscious biases which get in the way of making 'rational' decisions, though there is nothing 'rational' about investing!

Here is a quick tour of some of these biases:

• Home bias is a tendency to invest more heavily in your domestic markets. This adversely affects your geographical diversification, especially when you consider all the other investments you already have in your home turf: job, house, family, ….

Diversification

Diversification of assets is the opposite of having all of your eggs in one basket. Diversification is a way of reducing investment risk by spreading them across different risk factors, so that the likelihood of all risk factors taking a hit at the same time is reduced.

There are two main types of diversification:

• Vertical diversification is diversifying across different asset types, e.g. cash, government bonds, and equities.
• Horizontal diversification is holding a wide array of different assets within the same asset class, e.g. holding a total market index fund as opposed to investing 100% in Apple shares.

A diversified portfolio is about managing investment risks. When one part of your portfolio takes a hit, another may go up instead, so that, on average, you are better off with the diversified portfolio than you would have been with just the losing part of your portfolio. People will argue that, consequently, you will be worse off than if you had only invested in the winning part of your portfolio. And this would be a correct assessment, with the caveat being that nobody can foresee which part of the portfolio will be the winning side, and which the losing side. So sticking to a well-balanced well diversified portfolio and taking the average returns is a safer approach than betting everything on the losing horse.

How to choose your diversification strategy is covered in asset allocation. And remember that an investment portfolio changes over time. How to manage this is covered in portfolio rebalancing.

Another area to consider in the diversification stakes is that of geographical diversification, and avoiding home bias. The more geographical markets you are invested in the more resilient your portfolio should be to drops in any single market, though the increasingly connected nature of the global economy has made the international markets more correlated, there is still some gain to be had from geographical diversification. Also bear in mind that, as well as the typical home bias, we usually have many other assets and/or investments already tied up with our domestic market, such as jobs and housing, etc; and so should take this into account when considering a diversification strategy.

Asset classes

Asset classes are the various different types of investments you can add to your portfolio, and are the basis of a vertical diversification strategy. Different asset classes have different risk profiles, and by combining these in your portfolio you can increase its resilience against adverse market conditions.

The main three asset classes are:

• Cash and cash equivalents. These are the most liquid assets and include things like your domestic currency, i.e. the notes and coins you carry in your purse; foreign currency; cash equivalent assets like treasury bills and short-term government bonds.
• Bonds. These can come in investment grade bonds, or junk bonds. We are only talking about investment grade bonds here. Investment grade bonds can be government bonds, or corporate bonds. Bonds are seen as a safe asset, holding their value better than equities during a market downturn (they will still lose value, but less so).
• Equities which are stocks and shares are the riskiest asset of the three, but also provide the highest returns.

Other asset classes to mention are:

• Property, there are differing views as to whether, as a homeowner, you should include your main household in your portfolio.
• Commodities, e.g. gold, silver, oil.
• Alternatives, e.g. collectibles, hedge funds, private equity, digital currencies.

Asset allocation

The art of asset allocation is to find the right balance of investment assets to match your personal risk appetite. If you are a risk taker (and/or young!), and are looking to maximise your investment returns, you might go 100% into equities. If you are more risk averse, you may go 20% equities, 80% bonds. It is all about trying to find a balance in your portfolio between risk and returns that you are happy to live with (and in the passive mindset, then leave well alone!). Another thing that should be taken into account when deciding on an asset allocation is the investment time horizon. The longer your time horizon, i.e. when you want to start reaping the rewards of your investments, the riskier you can be with your investments, as they will have a longer time to both correct themselves (boom/bust cycles), and will also have a longer time for compound interest to work its magic.

Once you choose an asset allocation that works for you, write it down, as you will need to keep your investments following this allocation over time, and this will dictate how you feed new money into your portfolio, and also how you manage it in future, which is called rebalancing.

People's life outlook may also change over time, and therefore your risk appetite may change. I recommend not messing around with your asset allocation every year. The main point of passive investing is to make market returns over a long investment period. Regularly changing your outlook will likely have a detrimental effect on these returns, as your investments will start looking more like an active investment than a passive one. Reflecting on changed risk appetite every 5 years may be a better option.

What follows are a few classic asset allocation strategies for you to examine.

The 60/40 portfolio

A classical portfolio asset allocation is the 60/40 portfolio, where 60% of your portfolio is invested in equities, and the remaining 40% is invested in bonds.

TODO: talk a little more about the 60/40 portfolio.

You can use the basics of the 60/40 portfolio to move the percentages around to better suit your risk appetite and investment horizon.

Asset allocation rules of thumb

Some people have come up with some simple rules of thumb for working out your ideal asset allocation. I list some of these here so that you can have a think about what the pros and cons are for each rule of thumb, and whether you want to apply any to your own situation to help you come up with an initial asset allocation.

100 minus age

One popular rule that has been around for a long time is the `100 - your age` rule, which is meant to help you work out what your equities to bonds ratio should be, the answer being the percentage you should allocate to equities.

The idea behind it is that, as you get older, you should reduce your exposure to equities, as this is a more volatile asset class than bonds, which is more stable. This is because a big equity drop just before you are due to retire could seriously jeopardise your expected retirement income. This is a special case of something known as sequence of returns risk.

As longevity has increased, variations of this rule have turned up where instead of subtracting your age from 100, you use 110 or even 120 instead.

Other rules of thumb

Find more rules of thumb at Monevator towers.

Portfolio rebalancing

Once you have decided on an asset allocation that works for your personal risk appetite, can you just let go of the tiller and let the ship sail itself to your investment returns destination unaided? Not quite. Over time, depending on which assets in your portfolio do well, and which do not, your original asset allocation will get out of balance, and no longer reflect the original allocation you chose for your investments. This is all part and parcel of investing, and should be expected, even welcomed! What you will need to do is periodically nudge your portfolio back into balance, and this is what is called portfolio rebalancing.

When rebalancing a portfolio, the aim is to sell your best performers which will have ended up taking a higher percentage of your portfolio, and buy more of your lower performers to bring the asset allocation back into balance. You can do this at any time, but beware of transaction costs which will eat into your returns. For this reason, it is best to rebalance on a regular, but not too frequent, schedule. Quarterly or yearly should be fine.

Rebalancing strategies:

• Rebalance using new money only. The aim here is to reduce transaction costs by never having to sell your best performers. So when you are topping up your investments, work out the allocation of the new money in order to bring your portfolio allocation back in line with your originally chosen allocation. Beware that if your portfolio gets really out of kilter, rebalancing with new money only may never be enough to bring it back into line.
• Calendar based rebalancing. Ignore the state of your portfolio until a predetermined date (monthly, quarterly, yearly, …), at which point you bring your portfolio back in line with your chosen asset allocation. This can be done with both any new money added to the portfolio and/or by selling the best performers, etc.
• Threshold based rebalancing. This strategy aims to rebalance your portfolio when certain assets get out of line by a predetermined threshold % amount. There are various different types of threshold based rebalancing strategies.
• Hybrid rebalancing. Pure threshold based rebalancing requires you to keep an eye on your investments to ensure you rebalance once thresholds are triggered. A more "passive" approach is to combine calendar and threshold strategies so that you only check your portfolio on a periodic basis, and only rebalance those assets that have triggered a threshold limit.

Investment options

Once you have decided on an asset allocation that works for you there are various ways of putting this into practice, which range from completely hands off, to requiring a little more effort, perhaps a day or two every quarter or year.

One-stop shop funds

The Vanguard Group is the company that invented the consumer low cost index investment fund. They have also come up with a one-stop shop fund that provides all you need for a X/Y equity/bond allocation. These funds are called LifeStrategy X% Equity Fund where X% is the percent allocated to equities, and the remainder is allocated to bonds. They also provide a 100% equity fund, which does not have any bond component.

These funds have a static equity/bond allocation. If you are looking for an allocation that changes as you get closer to retirement age Vanguard also offer Target Retirement XXX Funds, where XXX is your target retirement date. These funds will increase the bond % allocation every year as you get closer to your target retirement date, usually up to some maximum fixed % bond allocation.

Index funds

An index fund is a fund of stocks and shares that tracks a publicly known market index. Well known indexes are:

• S&P 100, the 100 largest publicly traded US companies by market capitalisation.
• S&P 500, the 500 largest publicly traded US companies by market capitalisation.
• FTSE 100, the 100 largest companies listed on the London Stock Exchange by market capitalisation.

The above market indexes, though the most well known, are a little narrow in scope when being used in a passive portfolio. They can have a place in your asset allocation of choice, just be aware that these are concentrated stocks, and therefore reduce the amount of diversification in your portfolio. Other indexes available are known as "total market" indexes, and these attempt to reflect the market as a whole, rather than concentrating on a small number of stocks in that market. Other available index funds are "world" index funds, and these cover the whole world at appropriate percentages without the investor having to lift a finger.

Index based ETFs

There is another index based option which is the ETF, Exchange Traded Fund. These are similar to index funds, but they are traded as shares on an exchange, like the London Stock Exchange. There are a wide range of ETFs available, but one should be very careful when choosing ETFs as a lot of them are not what they seem, with differences between physical and synthetic ETFs being just one aspect to understand.

As always, understand the product you are investing in before you invest. See Monevator for a more in-depth account of ETFs vs. Index Funds.

Example allocations

Resources

Where can I find more information about investing?

My main source of information on all things investing (mainly passive investing) is the excellent Monevator blog.