What is Passive Investing?
In the investing world, there are two main types of investing: active and passive.
Active vs. Passive Investing
Active investing involves making constant updates to your portfolio, trading stocks very frequently. There are many perils that investors of this nature face. Besides the daily fluctuations of the stock market, active traders face brokerage commissions and short-term capital gains taxes. All of this eats away at potential returns. According to Nate Silver, the author of The Signal and the Noise, the average holding time of a stock is now roughly half a year:
Passive investing on the other hand involves a buy-and-hold strategy. You buy a stock (or index fund) and hold that stock for a long time, if not forever (as Warren Buffet seems to prefer). There are several ways to passively invest, including through index funds or ETFs, dollar-cost averaging through automatic purchases, and asset allocation. According to Investopedia, passive investing is:
An investment strategy involving limited ongoing buying and selling actions. Passive investors will purchase investments with the intention of long-term appreciation and limited maintenance…Unlike active investors, passive investors buy a security and typically don’t actively attempt to profit from short-term price fluctuations. Passive investors instead rely on their belief that in the long term the investment will be profitable.
What is Asset Allocation?
Asset allocation, simply, is the process of apportioning asset classes in your portfolio to your intended proportions based on risk and reward. If you want, say, your portfolio to consist of 70% stocks, 15% bonds, 10% REITs, and 5% cash, you would buy securities in those proportions, leaving 5% of your money in cash. The exact proportions vary on a individual basis, but there are some prescribed strategies that can be one-size-fits-all.
Why is Asset Allocation important?
Asset allocation ensures that you don’t have undue risk in any specific asset class. It protects you from large market fluctuations by ensuring your assets are weighted the way you want.
For example, let’s assume you have the asset allocation above initially with 70% invested in stocks. The stock market rallies throughout the year. At the end of the year when you check your asset allocation, you now have 75% of your portfolio invested in stocks. Let’s say that you do nothing and the following year the stock market rallies again, bringing your stock exposure to 80%. What happens if the stock market tanks the following year? You now have 10% more exposure to stocks, so you’d lose more.
How is Asset Allocation Passive Investing?
As stated above, passive investing means limited trading that helps control risk and reward. Asset allocation is generally performed on a yearly or quarterly basis, ensuring minimal trades. In addition, asset allocation ensures that you buy low and sell high. In the above example, your portfolio increased to 75% after a year. Let’s assume that these are dollar amounts and you instead have:
|Year 0||Year 1|
Buy Low, Sell High
Think of it as having one share in each of these asset classes. After the first year, your share in stocks went up by $5. However, your share in bonds went down by $3. If you were to reallocate, you’d be selling $5 worth of your share (this is purely hypothetical so selling a partial share is ok) and using three of those dollars to purchase a partial share of bonds at the discounted price of $12/share. This is a perfect example of buying low and selling high. You are selling some of your stock at a premium price while purchasing more bonds at a discount. This prevents you from trying to time the market, which is almost impossible for most people.
Recommended Asset Allocation Strategies
Now how do you implement asset allocation, you say? There are many ways and sometimes brokers even provide tools to help you (e.g. TD Ameritrade’s Portfolio Planner). Here are some of the ways you can implement asset allocation:
Target Date Funds
Target date funds have become quite popular over the past few years. Most common in employer-sponsored 401ks, target date funds seek to automate the process of asset allocation. You first choose which year you plan to retire in and invest your money in that fund. At least once a year, these funds will allocate funds based on your age, risk tolerance, and how many years are left until retirement. These are the best funds for the extremely lazy and passive investor.
ETFs and Index Funds
For the DIY investor, ETFs and index funds are probably the best way to use asset allocation. Pick a few funds that represent the asset classes you want, allocate your money to these funds, then once a year check the allocations and update as necessary. This is an extremely powerful strategy when combined with dollar-cost averaging.
If target date funds offer too little control for you, you can try using the following age-based allocations provided by Burton Malkiel, author of A Random Walk Down Wall Street. Notice how the portfolio reduces risk over time as the proportion allocated to stocks shrinks.
Thirties and Forties
A Forewarning on Allocating to Company Stock
Oftentimes, companies will allow you to invest money in their stock in your 401k, sometimes even giving you incentives for doing so (tax breaks, options, discounts, etc.). While investing in company stock is not a bad thing, be wary. Your salary comes from that company. What happens if your company goes the way of Enron? Not only does the stock tank, but you may be left with no job. You might be left with no salary and no savings because all your savings were invested in your company. My suggestion is to keep a maximum of 10% of your net worth in your company stock. This ensures that if such a scenario occurs, you have a cushion.
Personal Capital Can Help You with Asset Allocation
Personal Capital can help you with asset allocation with it’s slick asset allocation tool. As seen in the photo below, simply view your portfolio and then select “Allocation.” By clicking on each allocated section, Personal Capital allows you to view a further breakdown of what securities make up that bucket so you can adjust accordingly. The best part about Personal Capital‘s asset allocation tool is that they’re not trying to sell you stocks, bonds, funds, or anything else to help you reach the proper allocation, they’re just giving you a snapshot of your portfolio for free.
Asset allocation can help your portfolio a great deal, especially if you are not an active investor. However, remember that asset allocation or any other strategy we recommend here is not guaranteed to result in returns of any kind.