Building Wealth with Passive Investing
Passive investing is mostly a buy and hold investment tactic that is usually managed for the market's cycles. There are a variety of strategies investors can use to manage their portfolios. The investor can use one strategy for stocks and another strategy for index funds.
The common strategies used with passive investing are discussed as follows:
Dollar Cost Average
In its basic form Dollar Cost Averaging is the simplest strategy for the passive investor. With this strategy the investor contributes a fixed amount of money at a regular interval - which can be monthly, quarterly or even annually.
Dollar Cost Averaging is in effect a self adjusting strategy that deals with market cycles.
During a bull market stock prices work their way higher and during a bear market stock prices work their way lower. With Dollar Cost Averaging the investor ends up buying fewer shares when stock prices are high and buys more shares when stock prices are low. With this strategy investors typically end up buying a higher portion of shares around the bottom of bear markets which really boosts their portfolio returns during the next bull market.
While they are working most investors increase their Dollar Cost Averaging contribution over the years as their income increases.
Dollar Cost Averaging is particularly suitable to passive investing which is mostly a Buy and Hold strategy. Stocks are only occasionally sold when they no longer suit the investor's investment plan. Dollar Cost Averaging with passive investing makes it easy for the investor to build a portfolio with a large number of stocks.
Dollar Cost Average - Cycle Managed
This is the same Dollar Cost Averaging strategy but stock is only bought when the market is bullish. When the market is bearish the contributions are still deposited into the brokerage account but no stock is bought until the market conditions turn bullish again.
This strategy attempts to only buy stock during bull markets and avoids buying stock during bear markets.
The strategy can be quite effective during large bear markets such as the 2008 financial crises. The investor accumulates the Dollar Cost Averaging contributions in their brokerage account during the market decline and purchases stock with the accumulated amount when the market turns bullish again near the market bottom.
The investor can use techniques such as Dow Theory and/or long-term moving averages to determine when the market conditions are turning bearish. The strategy can also be used with the intermediate-term trend using a 50-day moving average.
Investors Age in Bonds
This is popular with financial planners when they set up a portfolio. Essentially this strategy states that the investor's portfolio should hold bonds with a percentage value that's equal to the investor's age.
So for an investor who is 30-years old with a $10,000 portfolio they should have Bonds worth $3,000 (which is 30% of the portfolio value) and should have the remaining $7,000 in stocks (which is the portfolio value less the Bond value).
As another example, an investor who is 60-years old with a $1,000,000 portfolio should have $600,000 in bonds (which is 60% of the portfolio value) and have the remaining $400,000 in stocks (which is the portfolio value less the bond value).
This strategy aims to reduce the investor's exposure to stocks as they get closer to retirement. Thus while the investor is young and has a long time until retirement they can afford to take on more market risk. This allows them to achieve higher returns with the more volatile stock market. As the investor ages the strategy re-balances so the investor has more of their portfolio invested in bonds which have a lower volatility.
The portfolio re-balancing is typically done annually at the same time of the year. Since stock and bonds have to be bought and/or sold for the re-balancing its generally best if the portfolio does not contain too many stocks/bonds as the brokerage costs can become excessive thus lowering the investors net return.
This strategy can be used regardless of whether the investor contributes with Dollar Cost Averaging.
Fixed Percentage Bonds
The Fixed Percentage Bonds strategy is similar to Investors Age in Bonds strategy. The difference is that this strategy uses a fixed percentage which is determined by the investor rather than a percentage based on age.
The following can be used as a guide: 25% bonds for aggressive investors, 50% for moderate risk investors and 75% for conservative investors.
As with the Investors Age in Bonds strategy, the investor re-balances their portfolio annually to maintain the desired ratio. Again it's best if the portfolio does not contain too many stocks due to brokerage costs and the amount of work involved in re-balancing.
This strategy is primarily intended to manage the market cycles.
As the bull market progressives, stocks increase in value and bonds often drop in value (as interest rates often increase during bull markets). Therefore the investor ends up selling some stock as prices climb and buys bonds which usually have dropped in price.
When the bull market ends the process reverses. Stock values fall and bond prices often increase. So the investor sells some bonds and buys more stocks.
Managing Market Reversals
With this strategy the investor attempts to stay in the market while the market remains bullish, but exits the market (or at least reduces their exposure) when the market turns bearish.
Market cycles can be managed using techniques such as Dow Theory or a long-term moving average.
Exiting an entire portfolio is only really viable for small portfolios. With a portfolio containing a large number of stocks the brokerage costs start to become excessive which can significantly reduce the investor's net returns.
The strategy is suited to a Buy and Hold portfolio as the investor is mostly buying during bull markets and only sells when markets turn bearish.
The strategy also works with Dollar Cost Averaging. During the bull market the investor buys stock with the contributions. During bear markets the investor keeps contributing into their brokerage account but they do not buy any stock until the next bull market has started.
Since the investor has accumulated a fairly substantial cash reserve during the bear market, they can buy a fair amount of stock right at the early stage of the next bull market. This gives their portfolio returns a real boost as the next bull market progresses.
The idea with this strategy is to remain invested while the market is bullish and be out of the market when it's bearish (or at least have a reduced exposure while the market is bearish)..
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