The Best Passive Investing Strategy
There are many ways to build wealth, but few are as reliable as the time-tested strategy of passively investing in stocks, bonds, and other assets that generate passive income in the form of dividends, interest, and rents. The passive investing strategy is based on the historical precedent that a low-cost, well-diversified portfolio held with low turnover will tend to produce an average market return without much thought.
Passive Investing Strategy
In essence, the passive investing strategy calls for:
- Buying a solid collection of 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 and reinvesting your dividends
- Keeping costs as low as possible
The evidence demonstrates that it works well under most circumstances because it protects investors from their own irrationality, lessens the need to understand accounting and finance, requires almost no time commitment, and is cheap.
The chart below shows the difference between passive and active U.S. equity funds in trillions from 2008–2018.
Many current investors are familiar with this concept because of 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 passive strategy. Bogle first discovered the mathematical foundation of why it 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. By 2014, the fund he brought to fruition, the Vanguard 500 Index, was the biggest of its kind anywhere in the world.
It held more than $190 billion in assets, had a turnover rate of only 3% (indicating the average stock is held for 33 years), and a mutual fund expense ratio of 0.17%. It single-handedly provided a secure retirement for more Americans than almost any other one-stop, individual financial product.
Connection With Index Funds
The passive strategy has been around forever, but it seems to peak in popularity every few decades. The easiest way to take advantage of this strategy is to buy index funds and 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 the investments for 25 years or more, the results have been extraordinarily lucrative despite some multi-year periods of gut-wrenching drops. However, for investors with substantial means, index funds are often a sub-par 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 people 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.
Strategy Without Index Funds
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.
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.
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.
One of the biggest objections you hear to the passive investing strategy has to do with bankruptcy—however, this much less of a risk than suggested. When the portfolio is made up of quality companies and spread among a diversified constituency, it's rarely a problem.
For example, the ING Corporate Leaders Trust held shares of Eastman Kodak, which went to virtually $0 before seeking protection from the bankruptcy courts. Despite ending in a terminal value of around $0 per share, Eastman Kodak has still made owners of the trust a massive amount of money over the decades in the form of dividends paid out across years. 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?
Investors who can best take advantage of the benefits of passive investing are going to be those who:
- Don't want to spend much time managing their assets
- Can let investments sit without interference
- Have long-term plans in place
It's easy to frequently check your portfolio and become discouraged by sudden drops or overly-enthusiastic about increases. However, these frequent checks go against the fundamental purpose of passive investing. Once you purchase shares, sit back and let the money and compound interest work for you.
Countless anecdotes exist of people throwing away ideal investment portfolios for fear of missing out on "the next big thing" they heard about somewhere. It's as if they forget that their portfolio's job is to make money in the safest way possible, not take on more risk trying to strike gold. Comfort with the reasoning behind underlying companies included in a portfolio in the first place should be the primary driver of any investment strategy, even if reported numbers differ from what the media says daily.