The Low-Cost, Widely Diversified, Passive Investing Strategy
The Simplest, Best Investment Strategy for Most Inexperienced Investors
There are a lot of ways to build wealth, and several different investing strategies that can get you to your ultimate goal of financial independence as your stocks, bonds, mutual funds, real estate, private businesses, and other assets generate passive income in the form of dividends, interest, and rents. I've written a series of articles looking at some of the most popular investing strategies that have produced a lot of self-made millionaires over the generations. This will allow you, as a new investor, to get acquainted with different terms, and understand the beliefs and temperaments that differentiate the way in which various family fortunes are amassed.
We're going to start with what is probably the single best-investing strategy for those who don't know what they are doing: The low-cost, widely diversified, passive approach (we'll abbreviate it as LCWDPA from here to save time). The low-cost, widely diversified, passive investing strategy is based upon the historical precedent that a sufficiently diversified, representative list of common stocks, held at the lowest possible cost, with the lowest possible turnover (taking advantage of deferred taxes), will tend to produce a market average return without a lot of thought.
In essence, the LCWDPA calls for:
- Buying a large collection of good, long-term holdings, balanced across multiple industries, sectors, market capitalization sizes, and even countries
- Never selling these holdings under almost any condition, no matter how distressed they appear to become
- Regularly buying more by depositing fresh cash into your brokerage account, perhaps even reinvesting your dividends
- Keeping costs as low as possible because every penny you save is another penny compounding for your family
The academic evidence clearly demonstrates that it not only works, but it works well under most circumstances because it protects investors from their own irrationality, lessens the need to understand accounting and finance (you won't have to know how to read an income statement or balance sheet), requires almost no time commitment, and is dirt-cheap.
The Connection Between This Investing Strategy and Index Funds
The LCWDPA has been around forever, but it seems to peak in popularity every few decades, coming and going in fads just like fashion or music (which is a shame, really, because it works so well for those who have the discipline to stick to it). The easiest way to take advantage of this investing strategy is to buy index funds, make regular, additional purchases through a practice known as dollar cost averaging, and let time do the rest. Though the past is no guarantee of the future, whenever an investor has followed this prescription, and held for 25 years or more, the results have been extraordinarily lucrative despite some multi-year periods of gut-wrenching drops.
That seems appropriate because, by all accounts, the most recent surge in this investment strategy can be credited to John Bogle, the founder of mutual fund company Vanguard, who built his career helping investors keep more of their money by evangelizing the underlying tenants of the LCWDPA. Bogle first discovered the mathematical foundation of why an LCWDPA works so well during a research project he did as a senior at Princeton University. That research led to his undergraduate thesis, which ultimately manifested itself in the very first S&P 500 index fund years later.
Today, the fund he brought to fruition - the Vanguard 500 Index - is the biggest of its kind, anywhere in the world. It holds more than $190 billion in assets, has a turnover rate of only 3% (indicating the average stock is held for 33 years), and a mutual fund expense ratio of 0.17% per annum. It has single-handedly provided a secure retirement for more Americans than almost any other one-stop, individual financial product.
Index Funds Don't Always Equal a Passive Investing Strategy
For investors with substantial means, index funds are often a sub-optimal choice if you want to take advantage of this particular investing strategy. As Bogle himself writes in many of his books, including an excellent tome called Common Sense on Mutual Funds, it is much more tax-efficient for men and women with a few extra zeros on the end of their net worth to forego mutual funds entirely and build a direct portfolio of individual stocks using the same indexing philosophy. Not only might expenses be lower than even the cheapest index funds, but the account owner can take advantage of another investing strategy known as tax-loss harvesting to minimize the percentage of the portfolio taken by the government.
A perfect example of what such an action might look like is the ING Corporate Leaders Trust. Back in 1935, the portfolio manager set out to build a collection of 30 blue-chip, dividend-paying stocks, which would be held forever, with no manager, and almost no fees or costs. Shares were only removed when they were acquired, went bankrupt, or suffered some other material event, such as a dividend elimination or debt default. Come rain or shine, hell or high water, depression, recession, war, peace, inflation, deflation, and every other imaginable scenario, the stocks were left untouched.
The portfolio paid out its dividends for owners to spend, save, reinvest, or donate to charity, and that was it.
As anyone who has looked at the academic studies on the topic might expect, this seemingly "dumb money" investing strategy -- which is even more passive than an index fund -- crushed the average mutual fund over the past 79 years, delivering a compounding rate nearly double its competitors. The list of companies is still amazing because former holdings were bought out by modern day empires. For example, an inexperienced investor might look at the original list of stocks and incorrectly conclude that Standard Oil of New Jersey and Socony-Vacuum Oil are now defunct.
On the contrary, they were bought out over the years and swapped for shares of Exxon Mobil, the current owner. The Atchison, Topeka & Santa Fe Railroad was bought by Burlington Northern Santa Fe, which was acquired for the stock by Warren Buffett's conglomerate, Berkshire Hathaway.
One of the biggest objections you hear to the low-cost, widely diversified, passive investing strategy from those who are ignorant of the mechanics of this approach has to do with bankruptcy. "What if some of the stocks go bankrupt and you lose everything you put into them?!" they exclaim as if they have proven a point. Nothing could be further from the truth. When the portfolio is made up of quality companies and spread out among enough constituents, it's rarely a problem. For example, the ING Corporate Leaders Trust we've been discussing held shares of Eastman Kodak, which went to virtually $0 before seeking protection from the bankruptcy courts.
However, despite ending in a terminal value of ~$0 per share, Eastman Kodak still make the owners of the trust a massive amount of money over the decades as a result of 1.) dividends paid out over the years, 2.) the spin-off of the chemical division and 3.) the tax loss credits that were achieved from the bankruptcy filing, shielding income from other, more successful investment holdings. Somehow, this is conveniently forgotten (or, more likely, unknown) by non-professionals who foolishly look at nothing but a stock chart, ignoring economic reality.
Who Is Best Suited for This Passive Investing Strategy?
Generally speaking, the individual investors who can best take advantage of the benefits of this money management school of thought are going to be those who:
- Don't want to spend a lot of time managing their assets. They don't relish the idea of reading 10K filings by the fireplace but would rather be doing other things with their friends and family.
- Are emotionally stable and can let their head rule their heart, not losing a wink of sleep when stocks crash (provided the underlying portfolio is made up of high-quality blue chips that don't change much from year to year, or even decade to decade; e.g., whether it is 1900, 1950, 2000, or 2050, people are still likely to use some form of Clorox to disinfect surfaces).
- Don't feel the need to "do" something. They can sit on their behind and take absolutely zero action, even if they think there are better uses for their money, sticking with the plan despite the boredom of twiddling their thumbs their entire life.
- Don't feel the need to look smart in front of their friends or coworkers. It may sound hard to believe, but I've watched countless people throw away ideal investment portfolios because they felt like they were missing out on some sort of gold rush they heard about when grabbing drinks with old college classmates. It's as if they forget the job of their portfolio is to make money in the safest way possible, not make them appear more interesting.
- Don't care whether they under or over perform a given index in a specific year. It's axiomatic but a portfolio like the ING Corporate Leaders Trust is going to wildly diverge in any particular time period from the S&P 500 or whatever index you care about because, by definition, it owns a different group of stocks. As long as you're comfortable with the reason the underlying firms were included in the portfolio in the first place, you should be happy with the investment strategy even if your reported numbers differ from what you're reading in the newspaper.
Learn About More Investing Strategies
Take a moment to read more related articles on TheBalance.com to find out if there is an investing strategy that fits your temperament better. For example, you might prefer a focused approach that calls for buying a handful of truly excellent businesses with strong financials and taking advantage of their superior economics. Alternatively, you might prefer to buy a list of common stocks that have increased their dividend every year for 10 or 25 years, happily hanging on as long as the checks you get in the mail grow larger with each passing season.