With the markets making a rebound, there’s a lot of talk about investment strategy. In particular, passive and active investment strategies. This is more of a beginner investor article so hopefully the more experienced investor readers out there can add to the comments.
To start, lets go over what passive investing actually means.
Passive investing is perhaps the investment style that is most popular among personal finance bloggers. This is where you buy and hold a basket of indices (via index ETF or mutual funds) for the long term. Every so often when new money is added, the portfolio is rebalanced to the appropriate asset allocation to the investor.
What is an index? An index, like the S&P500, DJIA or TSX are a group of stocks chosen to represent portions of the stock market. The weighting of the index is typically adjusted by the market capitalization of the underlying securities. In other words, if a large company on the index increases in value, it will represent more of the index.
Index mutual funds and ETFs basically mimic the index by buying the same basket of stocks at corresponding proportions and adjust accordingly. The reason why index ETF’s/mutual funds can keep their fees (MERs) lower is because normally the buying/selling is done automatically by computer and not an active fund manager.
There are many benefits of passive investing, some of which include:
- It’s relatively easy and takes very little time.
- Betting on the index beats an active mutual fund the majority of the time.
- Indexing costs a lot less than active investing, thus increasing returns over the long run.
- It takes the emotion (thus mistakes) out of investing.
A popular index investing strategy is the global couch potato strategy where the portfolio is split into 4 parts. Each part of the portfolio consists of an index. This includes a Canadian Index, US Index, International Index, and Canadian Bond index. As you can see, this type of portfolio will give ample equity diversification along with a portion for bonds. The percentage of equity/bonds really depends on your risk tolerance. The lower your risk tolerance for volatility, the higher your bond allocation. However, over the long term, the higher the bond allocation the lower your portfolio returns.
You can view my example of a low cost index ETF portfolio here. As well, below are some additional ETF’s that you can look into:
Tomorrow, we’ll discuss some active investing strategies. Stay tuned!