Episode #24: Using Passive Investment Strategies

Wealth Decisions Podcast Transcript for Episode #24 Using Passive Investment Strategies

Listen to this episode on Apple Podcasts or Spotify

Welcome to The Wealth Decisions Podcast, where each week I take 15 minutes or less to discuss crucial wealth decisions and mindset hacks to help you live a richer life.

I'm your host, Brian Muller, and I've been in the financial services industry for over 25 years, and I'm also a certified life and health coach.

And I have a passion for helping people make better decisions around their money and their life.

So for the sake of time, let's dive right into it.

In today's episode, we're going to be talking about passive investment strategies.

Now, this is a really important topic, and I think it can have a significant impact on your long-term financial success.

In the past few episodes, we talked a lot about developing a portfolio for you at your stage in life and risk tolerance.

And we talked and touched on briefly the importance of using ETFs or low-cost mutual funds.

Now, passive investing has, you know, gained tremendous popularity in recent years.

When I first got into the business in the late 90s, it was actively traded mutual funds were the predominant way to invest.

But today, ETFs make up a much larger part of the market.

And most ETFs are passive investment strategies.

You know, it's an approach that can offer simplicity, lower costs, and potentially better long-term returns compared to active investing strategies.

But what exactly is passive investing?

And how can you incorporate it into your financial plan?

That's what we're going to be covering today.

Let's just start with the basics.

Passive investing is an investment strategy that aims to maximize returns over the long term by keeping buying and selling to a minimum.

The idea is to match the performance of a specific market index rather than trying to beat it.

This in contrast to active investing where fund managers actively buy and sell securities in an attempt to outperform the market.

The most common form of passive investing is what I mentioned previously, and that's through index funds or exchange traded funds or ETFs.

And these track the market indexes whatever particular index you're trying to match, whether that's small cap or mid cap or you're just trying to mirror the S&P 500.

These funds just aim to replicate the performance of that target index by holding the same securities in the same proportions.

Now you might be wondering why would I want to just match the market instead of trying to beat it?

It's obviously the age-old question and there are several compelling reasons to consider passive investing.

Number one, passive investing strategies have much lower costs, very low expense ratios, much, much lower than actively managed funds because they require less research and fewer trades.

Two, they're pretty consistent performance.

When you look at an active mutual fund that tries to outperform in some years, studies have shown that the majority of active funds actually underperform their benchmark indexes over the long term.

So when you buy an index, you know what you're going to get.

You're going to match that index, you're going to get broad diversification, and you're going to get simplicity.

Passive investing can be just a much simpler way to implement a portfolio strategy compared to active strategies.

You also get a ton of tax efficiency.

With less buying and selling going on, passive funds tend to generate fewer taxable events.

So a passive ETF is a much better investment to hold, for instance, in a taxable investment account.

So now that we understand a little bit of the basics and benefits of passive investing, let's explore how you can implement this strategy into your own portfolio.

Here are some kind of key things to consider.

Number one, I talked about this in the past two episodes, is determine your asset allocation.

Before you start investing, it's really critical to determine the right mix of stocks, bonds, and other assets based upon your financial goals, your risk tolerance, and your time horizon.

This is the one area where active decision making is still important, even in a passive type strategy.

Step two would be to look at choosing the index funds or ETFs that you're going to use.

Look for funds that track broad market indexes with low expense ratios.

Some popular options include the total stock market index funds, S&P 500 index funds, international stock mutual funds, and bond market index funds.

Step three would be to implement that plan.

Once you've chosen the funds that you're going to invest in or the ETFs that are passive strategies, invest according to your predetermined asset allocation.

And then step four is to monitor that portfolio, rebalance on a periodic basis, because even with a passive strategy, you'll need to rebalance your portfolio occasionally to maintain that target asset allocation.

This might be done annually or maybe when your allocation drifts 2%, 3%, 5% from a threshold that you determine.

And the fifth thing to consider when investing in passive strategies is just to stay the course.

You know, one of the biggest advantages of passive investing is simplicity, but it also requires discipline.

You might have the urge to react to short-term market movements or switch to active strategies, you know, based upon recent performance of a particular part of your portfolio.

There's three different ways that you can use passive investment strategies in your portfolio.

You can buy index mutual funds, and these are mutual funds that track a specific market index.

They offer simplicity and often have really low minimum investment requirements, making them a little more accessible to most investors.

Number two, we've talked about this in the past few episodes, and in this episode is to invest in exchange-traded funds.

ETFs are similar to index mutual funds, but they trade like stocks in exchange.

They often have lower expenses than index mutual funds and offer a little bit more trading flexibility.

Number three, you could buy a target date fund.

These funds automatically adjust the asset allocation as you approach a target date, which would usually be retirement.

While they're not purely passive, many of these use index funds as their underlying investments.

And if you don't use a financial advisor, there's always the option of using a robo advisor.

There's digital platforms out there that use algorithms to create and manage passive portfolio.

You won't have a relationship with an individual advisor that can guide you and help you make important decisions.

But this can be a good option if you just want a hands-off approach and a simple portfolio that is tailored to your risk tolerance.

The only real downfall of a robo advisor is they don't know you personally.

They don't know your goals.

They don't know your dreams.

They don't know what your financial plan entails.

But if you're looking for a simple way to invest, this could be a good option.

Now let's just talk about some of the common questions and maybe misconceptions about passive investing.

I often get the question, isn't passive investing just settling for average returns?

You know, I think while it's true that passive investing aims to match market returns rather than beat them, it's important to remember that the average active fund manager underperforms the market after fees.

By aiming for market returns with lower costs, you may actually end up ahead of many active investors.

Another question I get is, don't I need active management to protect me in a down market?

It's a common belief that active managers can protect you during market downturns, but historical data doesn't really support this.

In fact, many active managers struggle to time the market effectively.

And some of those active money managers, their funds are just way too big to be able to make quick decisions to get in and out of the market because they can potentially move the market because of the size of their fund.

Another question that comes up from time to time is, can I combine passive and active strategies?

And I truly believe there's areas of the market where active money management can add value to your portfolio.

Some investors use kind of a core satellite approach, where they take the core of their portfolio, maybe that's 70% to 80% in broad-based passive ETFs and index mutual funds.

And then they seek additional returns with maybe sector funds or emerging markets or other things that can maybe potentially add returns on top of the index type returns.

So let's just talk a little bit about how to get started with passive investment strategies.

Number one is just to educate yourself.

Read some online blogs about ETF investing.

Learn about all the different index funds and ETFs available in the market.

There are thousands of them to choose from.

Understand their expense ratios, their tracking error and the particular indexes they follow.

Number two is just to start small.

If you're new to passive investing, you don't need to overhaul your entire portfolio at once.

You can start by just allocating a portion of your investments to a broad market index fund and then start building it out from there.

Analyze the mutual funds that you have and compare those to ETFs in that same category.

If the performance doesn't stack up and you're paying triple the fees, then consider some type of ETF to replace that mutual fund in that particular category.

And number three, you want to consider the different types of accounts that you have and what strategies to use in those different accounts.

Your 401k, you're usually limited to the options that are in your plan.

Typically, a lot of those are passive investment strategies or low-cost index funds.

In your IRA or Roth IRA, you could use a combination of some active mutual funds in certain categories and the rest in passive investment strategies to cover those areas of the market for broad diversification.

But if you have money in a taxable investment account, that is where passive investment strategies are the most beneficial because they're not actively managed.

There's not buying and selling going on throughout the year typically.

And so they're very tax efficient and you won't get those big capital gains if the markets do well in a particular year.

So as we wrap up today's episode, I just want to address a few final points about passive investing.

Number one, it's not an all or nothing approach.

I think you can incorporate passive strategies in your portfolio and use them alongside some active strategies.

Number two, passive doesn't mean inactive.

You know, while the investments themselves are passively managed, you still need to actively manage your overall financial plan, including your asset allocation and risk management.

You know, I think one of the biggest advantages of passive investing is that it helps investors avoid the common behavioral mistake of chasing performance.

So a lot of times an investor will look at a really good actively traded mutual fund.

And because it did really, really well, the last three years or five years, they choose that fund, assuming that that performance of that particular fund will continue into the future.

But the main benefit from passive investment strategies is cost.

You know, we've talked about this before, but it's just worth repeating the lower costs associated with passive investment strategies can have a significant impact on your long-term returns.

You know, even a difference of 0.5% in annual fees can add up to tens of thousands of dollars over decades of investing.

Just remember the most important aspect of any investment strategy is that it aligns with your personal financial goals, your risk tolerance, and time horizon.

Passive investment strategies can be a great way to reduce costs, which in turn will help build your wealth more over time.

And that's it for today's episode, Using Passive Investment Strategies.

Listen to this episode on Apple Podcasts or Spotify


-Brian D. Muller, AAMS® Founder, Wealth Advisor

Momentous Wealth Advisors in a fee-only fiduciary advisory firm

Disclaimer: This material is for informational purposes only and should not be construed as investment advice. Past performance is not indicative of future results. Investors should make investment decisions based on their unique investment objectives and financial situation. While the information is believed to be accurate, it is not guaranteed and is subject to change without notice.

Investors should understand the risks involved in owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates and investors can lose some or all of their principal.

Always consult with a qualified financial professional before making any investment decisions.