Passive investing has advantages that give it the potential to out-produce an active investing approach -- but only if it's done correctly. Because passive investing epitomizes "buy and hold," choosing the right investments from the start is crucial to generating those high returns.
What is passive investing?
Passive investing is an investment strategy that seeks to minimize transactions. The idea is to pick out the right investments and hang onto them as long as possible, only replacing them if it becomes clear that the investments are no longer worth holding.
Since passive investors have few transactions, they also have minimal expenses to erode away their returns. Fees, commissions, and capital gains taxes all occur largely as a result of transactions, so if you have no transactions, your costs will be much lower than an active investor's.
Even if your reported returns are somewhat lower than those of said active investors, you can still come out ahead thanks to your much lower expenses. For example, if your portfolio returns 7% this year and your neighbor's actively managed portfolio returns 10%, it might seem like you didn't do as well as he did. But if your fees and taxes were just 0.5% of the total portfolio value while his totaled 4%, you outperformed him in the final analysis.
So how can you make your investments work for you through passive investing? Here are five tips for getting started.
1. Choose index funds/ETFs
Since a major advantage of passive investing is lower costs, it's important to maximize that advantage wherever possible. Index funds and ETFs provide a powerful way to do so. Because these funds are themselves passively managed, expense ratios are typically much lower than those of actively managed funds. And while a passive investor could simply pick out his own stocks, he's likely to get far better diversification by buying into a few different index funds instead.
2. Seize every tax advantage
And while we're on the subject of cutting costs, reducing your tax bills can help you save a significant amount of money every year. The easiest way to reduce tax-related investment expenses is to keep the bulk of your investments in a tax advantaged account such as an IRA, 401(k), or HSA. All of these accounts allow you to collect dividends and interest without paying taxes on the money as it comes in and exempt your investments from capital gains taxes. Tax-deferred accounts such as traditional IRAs and 401(k)s give you a tax break on the money you contribute, while Roth versions of these accounts give you your tax break on the withdrawals. HSAs provide tax breaks on both contributions and withdrawals, making them the only triple-tax-advantaged account.
3. Allocate your assets wisely
Diversification is a powerful risk management tool, and it doesn't stop at choosing stocks from different industries. You must also diversify at a higher level by choosing several different types of investments. At a minimum, split your investments between stocks and bonds while holding onto a small cash reserve for emergencies. Some investors will wish to diversify further by purchasing other types of investments, such as real estate or commodities.
Your goals and risk tolerance levels will determine how much of your money should be in stocks versus bonds. If you're not sure how to split your long-term investments, you can use the formula of 110 minus your age to determine what percentage of your funds should be in stocks versus bonds. For example, a 30-year-old using this formula would have 80% of her investments in stocks with the other 20% in bonds.
4. Look overseas for investment options
Continuing our theme of "diversification is king," you can further spread your risk by putting a small percentage of your money into offshore investments. Foreign investments often perform differently from domestic ones, giving you an added layer of protection should the US stock market take a dive. Fortunately, buying into foreign investments is extremely easy these days thanks to the number of funds and ETFs that specialize in such investments.
5. Choose a discount broker
Finally, since you won't need to do a lot of transactions you don't need an elaborate trading system. A discount broker that provides a decent level of service and charges a minimum of fees is an excellent choice for any passive investor. Many discount brokers allow you to buy shares of their own funds and ETFs free of charge, so pick one whose funds you like and set up an account. With the right choice of broker, type of account, and investments, you could set up and maintain an excellent portfolio practically free of charge.
The Motley Fool has a disclosure policy.