Building Wealth with Passive Investing
Simple Wealth Building Strategies
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)..
Bonds and the Stock Investor
The main reason stock investors include bonds in their portfolio is to reduce volatility. Portfolio returns vary from year to year and bonds help to reduce the amount of this year to year variation. The downside is that bonds also reduce the portfolio's long-term returns since the returns from bonds are generally a fair bit lower than the returns from stocks.
In order to make the portfolio returns smoother the investor ends up with a lower long-term portfolio return. So the investor needs to weigh up the pros and cons of including bonds in a stock investing portfolio.
Bonds vs. Stocks
Treasury bonds are essentially guaranteed so the investor receives the face value when the bond matures and they receive the interest payments. With stocks the investor may receive a capital gain and may receive a dividend payment - neither of which are guaranteed.
So to compensate for the increased risk the investor receives a higher return over the long-term with stocks but in the short-term the returns from stocks may well be negative.
Bonds vs. Stocks
- If the investor buys a newly issued 10-year U.S. Treasury bond they will receive around 2.5% interest payment per year (current rate) and will receive the face value when the bond matures in 10-years (the price paid for a newly issued bond is essentially the face value).
- If the investor buys an S&P 500 index fund they will mostly likely receive around 2% in dividends in the first year with the dividends most likely increasing over the next 10-years and will most likely have a capital gain in 10-years time (but the dividends and capital gain are not guaranteed).
Therefore with Treasury bonds the investor receives back their original investment with no capital gain (but it's guaranteed to return their original investment). With stocks there is significant potential for capital gains (but the original amount invested is not guaranteed).
At present, both Treasury bonds and the S&P 500 index funds pay around 2%. The Treasury bond interest payments are guaranteed for 10-years at the current rate whereas for stocks the dividends are not guaranteed but tend to increase over the years.
Stocks generally produce a capital gain over a ten year period and the dividends generally increase in line with the growth in the economy. With shorter periods like five years, the market value of the stock portfolio may be worth more or may be worth less than the original investment. This is one of the reasons Treasury bonds are used - they provide a guaranteed return of capital. This capital guarantee suits those investors who need the capital security in the shorter term.
A good example of this capital security is when stock investors with aggressive portfolios start to approach retirement age. They now sell down their stock holdings and buy bonds so that their significant stock capital gains obtained over the decades are now secured (since bonds provide capital security).
Including bonds is generally appropriate for investors with time frames less than ten years and/or investors who need to secure their stock capital gains or for investors who need capital security.
For time frames greater than ten years and especially twenty years or more, the investor needs to question whether including bonds is appropriate as they do reduce the long-term portfolio returns available.
Investment grade corporate bonds generally pay one or two percent more than U.S. Treasury bonds. The downside with corporate bonds is that they are generally callable, meaning if interest rates drop then the company typically recalls their bonds and issues new bonds that pay the lower interest rates. This means the investor losses their higher interest bonds when interest rates drop.
Also corporate bonds are not guaranteed, so if the company goes bankrupt the investor generally loses most if not all of their original investment. Also the interest payments are not guaranteed which means if the company who issued the bond has insufficient cash flow then they skip that interest payments and there's no catch up for missed payments.
The bankruptcy risk is small and most investment grade bonds regularly make their interest payments, they are however not guaranteed.
Since there's some risk with corporate bonds it's generally a good idea to construct a diversified portfolio rather than simply buying one or two bonds. However for most small accounts this is not practical so a good alternative is to invest in a bond mutual fund. This way the investor is assured of a diversified bond portfolio.
Selecting Stocks and Funds
The passive investor may have started investing with a simple portfolio which may consist of some Dow Industrial stocks or maybe an index mutual fund. The investor looking to expand their portfolio should keep their existing portfolio and simply include more stocks and/or funds. There's no need to sell the portfolio you started with just because it's perceived to be a beginner portfolio.
For passive investing it's best to select from fundamentally sound stocks. A passive investing portfolio should mostly hold low risk stocks rather than speculative or financially distressed stocks.
These's a variety of techniques the passive investor can use to find suitable stocks to add to their portfolio.
Finding Stock Candidates:
- Include more stocks from the Dow industrial index or even look at the stocks in the S&P 100 or even check the stocks in the S&P 500. The more adventurous investor could consider stocks from the S&P MidCap 400.
- Use a web-based stock screener. There are dozens to choose from (both free and paid). The investor could use the free screener from nasdaq.com
Irrespective of how the investor finds their potential candidates, it's always a good idea to check the five year or even ten year revenue and earnings history. The safer stocks to buy are those with generally increasing revenues and generally positive earnings. The investor should consider performing some basic fundamental analysis before committing to buy. The investor can use an information service like morningstar.com which provides at least 5-years historical data for free.
The passive investor should consider selecting some stocks that pay dividends. These give the portfolio returns a boost and it's nice to receive a cash payment.
The passive investor can consider including small-cap growth stocks but only pick the fundamentally sound stocks with profitable business. Passive investing holds the stocks for many years which gives the companies plenty of time to grow and expand their revenue and earnings.
Index funds are low cost to own but investors is limited to the market return. Stocks have the potential to produce higher gains but can also produce lower returns than index funds.
Passive investors can consider other funds such as growth funds, value funds and dividend funds. If the investor is considering including these funds they can search the fund provider websites or broker websites for the appropriate fund or funds.
The investor should carefully check the prospective for fees as these can be quite high and they reduce the net return available.
Exchange Traded Funds (usually referred to as ETFs) are a form of mutual fund that is bought and sold on a stock exchange in exactly the same way stocks are bought and sold.
With ETFs the investor has to buy whole shares like with stocks (you cannot buy halve a share or quarter of a share).
Table 1. below shows two of the most popular ETFs available (data based on Dec 13, 2016).
Table 1. Stock Index ETFs
Referring to Table 1. above, the first ETF tracks the S&P 500 index and is affectionately referred to as the Spider's with reference to its ticker symbol SPY. The second ETF tracks the Dow Industrials index and is affectionately referred to as the Diamond's with reference to its ticker symbol DIA.
While ETFs are usually associated with index tracking funds there are other funds available such as growth funds and value funds. If the investor is interested in these ETFs they can obtain more information on their broker's website.
Stock Mutual Funds
The main providers of No-Load index tracking mutual funds are Fidelity and Vanguard. These funds have fairly high initial investment minimums. A low $100 minimum initial investment fund is provided by Schwab.
Table 2. below gives a list of mutual funds that track the S&P 500 index (data based on Dec 13, 2016).
Table 2. Stock Index Mutual Funds
The minimum investments vary as do the fees.
The investor can consider including other mutual funds such as growth funds, value funds or dividend funds. These can be found by searching the fund provider websites or checking the broker's website.
Buying corporate bonds is only really viable for investors with large accounts as the investor should buy a diversified portfolio of corporate bonds. With Corporate bonds consider buying a fund.
With U.S. Treasury bonds the investor does not need such a varied diversified portfolio and the bond sizes are only $100 (which means that most investors can easily buy them). They can be bought directly through treasurydirect.gov or can be bought through most stock brokers.
Treasury Bond ETFs
Table 3. below shows a selection of U.S. Treasury bond ETFs with various holding periods (data based on Dec 13, 2016).
Table 3. U.S. Treasury Bond ETFs
Treasury bond ETFs provide the investor with a bond portfolio containing a range of maturities. Keep in mind that when buying ETFs the investor buys shares just like when buying stocks (there's no fractional shares, only whole shares).
Corporate Bond ETFs
Table 4. below shows a selection of U.S. Corporate bond ETFs with various holding periods (data based on Dec 13, 2016).
Table 4. U.S. Corporate Bond ETFs
Corporate bond ETFs provide the investor with a diversified portfolio of bonds. Keep in mind that when buying ETFs the investor buys shares just like when buying stocks (there's no fractional shares, only whole shares).
Treasury Bond Mutual Funds
Table 5. below shows a selection of U.S. Treasury bond mutual funds with various holding periods (data based on Dec 13, 2016).
Table 5. U.S. Treasury Bond Mutual Funds
The above mutual funds are no-load funds. They all have a minimum initial investment requirement (but there's no minimum for ongoing contributions).
Corporate Bond Mutual Funds
Table 6. below shows a selection of U.S. Treasury bond mutual funds with various holding periods (data based on Dec 13, 2016).
Table 6. U.S. Corporate Bond Mutual Funds
The above mutual funds are no-load funds. They all have a minimum initial investment requirement (but there's no minimum for ongoing contributions).
The Cyclic Nature of the Stock Market
Stock Market History
The stock market provides one of the highest long-term investment returns available. The long-term return from stocks is significantly higher than bonds, CDs and other cash based savings investments, but the returns are also quite volatile. This means that the year to year capital gains vary considerably and there are significant variations during the year.
While today's stock market is volatile, it used to be even more so. Before 1945 the stock market was fueled by speculators who in those days had no fundamental understanding of the markets. Stocks where largely viewed as something to bet on rather than invest in. This was because most investors back then had no real understanding of businesses or their value.
The stock market crash of 1929 started a bear market that was excessive as the investors had no understanding of when a company was cheap and drove stock prices to insanely low levels that were way below book value.
Unfortunately for investors back then there was no monetary policy to spur on the economy and the end result was the great depression of 1930s. This ultimately led to the Nazi occupation of Europe and World War II.
The stock market is far more stable nowadays with aid of monetary policy and investors being more financially educated.
Market Cycle Theory
The stock market cycles its way higher over the decades with a never ending sequence of up cycles (we call these bull markets which last two to ten years) followed by the smaller down cycles (we call these bear markets which last six months to two years and occasionally three years).
Each bull market itself contains a sequence of up and down cycles. This means that the bull market does not go up in a straight line, but bounces up and down as the market works its way higher. The same sequence of up and down cycles also occurs within the bear market cycle as the market works its way lower.
The net result is that the stock market works its way higher over the long-term and this is the reason why stock investing is best viewed as a long-term proposition. In the short-term it can be quite volatile.
Graph 1.below shows the typical market behavior.
Graph 1. The Cyclic Nature of the Stock Market
The above graph depicts the markets general behavior. The label RH stands for "Relative High" and denotes the top of an intermediate-term uptrend. The label RL stands for "Relative Low" and denotes the bottom of an intermediate-term downtrend.
The stock market alternates between these intermediate-term uptrends and intermediate-term downtrends in a never ending sequence of cycles. A bull market continues for as long as the sequence of intermediate-term trends broadly heads upwards. A bear market continues for as long as the sequence of intermediate-term trends broadly heads downwards.
As a general rule, there are more intermediate-term trends within a typical bull market cycle than there are in a typical bear market cycle. This is why bull markets are on average longer than bear markets and because of this the market ultimately works its way higher over the long-term.
Actual Market Examples
Chart 1. below shows how the theoretical market behavior from Graph 1. above is applied to the actual market S&P 500 index.
Chart 1. The Cyclic Nature of the S&P 500 Index
The labels from Graph 1. are applied to Chart 1. for the S&P 500 index.
As Chart 1. shows, the low of the bear market (label C) actually dropped just below the bottom of the previous bear market (label A). Generally the RH and RL levels increase as the bull market progresses. A lot of bear markets only show one set of RH and RL.
On Chart 1. note that label A is also an RL and label B is also an RH. Similarly label C is an RL and label D is an RH.
During a bull market a Rally runs up from an RL to an RH and can last for many months and even a year or two. The Pullbacks decline from an RH to an RL and are usually quite short lasting only a few months.
During a bear market the Corrections take the market from an RL down to an RH and this can last for many months. The Bear Rally climbs from an RL to an RH and are usually a bit shorter being a few months long.
Chart 2. below shows another example of the theoretical market behavior from Graph 1.
Chart 2. The Cyclic Nature of the S&P 500 Index
The labels from Graph 1. are applied to Chart 2. for the S&P 500 index. In this example the index essentially traded straight down during the bear market without any significant rally. Hence there's no RH and RL shown from label B to C.
The S&P 500 Index
The S&P 500 index was introduced to the market in 1957 as an index that was more representative of the U.S. economy than the Dow Industrial index.
The S&P 500 index provided back tested data to 1925 based on the historical prices of the stocks that made up the index. This was for comparative purposes with the Dow Industrial index.
Chart 3. below shows the S&P 500 index since the end of World War II (actual index performance since 1957 and back tested performance prior to 1957). The chart also shows the labels A to D from Chart 1. and Chart 2.
Chart 3. The Markets Long-Term Upward Direction
As Chart 3. above shows, the stock market continues to work its way higher with a never ending sequence of bull markets and bear markets each containing a sequence of intermediate-term uptrends and intermediate-term downtrends.
Typically investors fear bear markets, but there's no reason to fear them. Bear markets are a natural part of the market cycle. While during bear markets the value of investors' portfolios decline, this is only temporary and they do provide savvy investors with fantastic buying opportunities. After the bear market ends a new bull market begins which typically takes the investors portfolio values to new highs.
Investors interested in seeing all of the Market Cycles over the last 100 years can find them in the members section.