You can build wealth in many ways, but the approach of investing in stocks, bonds, and other assets that produce passive income is time tested. This income can be in the form of dividends, interest, or rents. The passive strategy is based on the premise that a low-cost, well-diversified portfolio that's held with low turnover will tend to produce an average market return without much trouble or thought.
- The passive investing strategy is based on the premise that a low-cost, well-diversified portfolio will produce an average market return.
- One easy way to take advantage of the passive strategy is to buy index funds. Make regular purchases. Let time do the rest.
- It's more tax-efficient for wealthy investors to forgo mutual funds. Build a portfolio of stocks using the same philosophy instead.
- Passive investing is best for those who don't want to spend much time managing their assets. They can let investments sit, and they have long-term plans.
Passive Investing Strategy
The passive investing strategy calls for buying long-term holdings balanced across many industries, sectors, market capitalization sizes, and even countries. Never sell these holdings, no matter how distressed they might appear to become. Regularly buy more by depositing fresh cash into your brokerage account. Reinvest your dividends, keeping your costs low.
This strategy protects you from acting on emotion. It needs almost no time commitment, and it's cheap. The chart below compares passive and active U.S. equity funds in trillions from 2008 through 2018.
The History of the Concept
Many investors are familiar with this concept, thanks to John Bogle, the founder of mutual fund company Vanguard.
Bogle built his career helping investors keep more of their money by touting the passive strategy. During a research project he did as a senior at Princeton University, he found the mathematical foundation of why it works so well. That research led to his undergraduate thesis, on which he based the very first S&P 500 index fund years later: the Vanguard 500 Index.
This fund was the biggest of its kind in the world by 2014. It held more than $190 billion in assets and had a turnover rate of only 3%. That means the average stock is held for 33 years. The mutual fund expense ratio was 0.17%. The Vanguard 500 Index has provided a secure retirement for more Americans than almost any other product.
The Connection With Index Funds
The passive strategy seems to peak in popularity every few decades. The easiest way to take advantage of it is to buy index funds. Make regular purchases through a practice known as "dollar cost averaging." Let time do the rest.
While the past is no guarantee of the future, the results have been very good despite some multi-year periods of severe drops. This presumes that you've held the investments for 25 years or more, but index funds are often a subpar choice if you have substantial means.
As Bogle writes in many of his books, it is much more tax-efficient for people with a few extra zeroes on the end of their net worth to forgo mutual funds. They can build a direct portfolio of individual stocks instead, using the same indexing philosophy.
Expenses can be lower than those of even the cheapest index funds, and the account owner can take advantage of a strategy known as "tax-loss harvesting" to minimize the portion taken by the IRS.
Strategy Without Index Funds
The ING Corporate Leaders Trust is a good example of what such an action might look like. The portfolio manager set out to build a collection of 30 blue-chip dividend-paying stocks back in 1935. They would be held forever, with no manager and almost no fees or costs.
Shares were only removed when a company was acquired, went bankrupt, or suffered some other major event, such as a dividend elimination or debt default. The portfolio paid out its dividends for owners to spend, save, reinvest, or donate to charity. That was it.
This "dumb money" strategy is even more passive than an index fund. It crushed the average mutual fund over the years, delivering a compounding rate nearly double that of others. The list of companies is still amazing, because former holdings were bought out by modern-day empires.
You might look at the original list of stocks and incorrectly conclude that Standard Oil of New Jersey and Socony-Vacuum Oil are defunct, but they were bought out over the years. They were swapped for shares of Exxon Mobil, which bought them.
One of the biggest objections you might hear to the passive investing strategy is bankruptcy, but that is much less of a risk than it's said to be. It's rarely a problem when a portfolio is spread among solid, diversified companies.
The ING Corporate Leaders Trust held shares of Eastman Kodak. The shares went to virtually $0 before Eastman sought protection from the bankruptcy court. Eastman Kodak has still made a massive amount of money over the decades for owners of the trust, despite ending in a terminal value of around $0 per share.
The spin-off of the chemical division and the tax-loss credits secured from the bankruptcy filing shielded income from other more-successful investment holdings.
Is Passive Investing Right for Me?
You can best take advantage of the benefits of passive investing if you don't want to spend much time managing your assets. Your investments can sit without interference because a long-term plan is in place.
It's easy to check your portfolio often and panic over sudden drops, or feel overly hyped about increases. But these checks go against the basic purpose of passive investing. Sit back and let the money and compound returns work for you after you purchase shares.
Countless stories exist of people throwing away ideal portfolios for fear of missing out on "the next big thing." They forget that their portfolio's job is to make money in the safest way possible, not to take on more risk trying to strike gold. Comfort with the companies included in a portfolio should be the prime driver of any strategy, even if reported numbers differ from what the media tells you daily.
Frequently Asked Questions (FAQs)
What is the natural limit to passive investing?
Active investing offers the chance to outperform indexes and other investors. Passive investors are guaranteed that their performances will match the market average for their given investment targets.