Passive Investing – Rookie Addition [Post 2]

Disclaimer

This post is an outline for a common investing strategy using Vanguard funds as an example, this is not a specific recommendation. The sample portfolios provided are categorized as highly aggressive. Those considering this investment philosophy should anticipate holding funds for 20+ years or should be aware of the increased risk associated with not doing so.

Who Could Benefit from Reading

• Young professionals that are serious about their financial goals

Why You Should Care

Post 1 outlined the downfall of allowing your cash reserves to be eaten away by inflation. This post will serve as a passive investing guide to possibly outpace inflation and generate growth over time.

What is Passive Investing?

A buy-and-hold portfolio strategy involving minimal trading. Exchange-traded funds (ETFs) are baskets of investments commonly used in this strategy to mirror the performance of a broad market. Passive investing tends to be cheaper, less complex, and often produces superior after-tax results to actively managed portfolios.

Chen, J. (2021, May 19). Passive Investing. Investopedia.

A Fork in the Road

This post offers two levels of complexity for beginning investors - Path 1 and Path 2. Both deliver a framework for passive investing but are written for vastly different individuals.

• Path 1 - will be a speed run through the barebones of becoming a passive investor. This will be adequate for those that know they should do something but like the idea of setting this up once and having no obligation to look at it again for a long time.

• Path 2 - will slow down and take a deeper dive into diversification, rebalancing, and other aspects of “Why?”. This strategy can potentially improve returns, lower risk, and should take precedence over the first path for anyone willing to put a little extra effort in.

Path 1 – One Size Fits All

1. Open an online brokerage account that offers $0 trading fees on ETFs, fractional share investing, and a recurring investment plan. Fidelity, Charles Schwab, and Robinhood are examples.

2. Find a broad market index ETF, such as the S&P 500, with a low expense ratio. Vanguard’s fund (VOO) contains shares from 500 companies and has an expense ratio of 0.03%.

3. After an initial purchase, start a recurring investment into this ETF of choice. If this is the only location you invest, start with 10-30% of your paycheck into the fund on a bi-weekly or monthly basis and see if that works for you.

4. Enable dividend reinvestment so any cash paid out will be placed back into the funds, otherwise cash will pile up and sit dormant in the account.

Done! It really can be that simple, and historically effective too. The S&P 500 has yielded over 11% annualized returns since its adoption of the 500-company system in the 1950s and tends to pay out a dividend. In a world where a similar result takes place moving forward, that’s not a bad return on investment for someone that spent a few minutes setting this up and never opened the app again.

Path 2 – The Globetrotter

*The actual first step in Path 2 is to decide between ETFs or Mutual Funds. The two are similar in nature and will be suitable for different people. Elect ETFs if you like tax efficiency and limiting fees. Elect Mutual Funds if you value the ability to outperform/underperform the market and have more than $12,000 investable dollars (account and fund minimums are common). We will be choosing an ETF portfolio for this walk-through; ETFs are typically more accessible to retail investors.

1. Open an online brokerage account that offers $0 trading fees on ETFs, allows fractional share investing, and a recurring investment plan. Fidelity, Charles Schwab, Robinhood, and many others are all examples. Robinhood offers a user-friendly interface and biweekly recurring investing. These features mold well for mobile use and if you also receive your paycheck biweekly. The inability to purchase fixed income instruments (bonds) and fees associated with transferring funds to another platform are downsides of Robinhood.

2. Selecting ETFs. An efficient portfolio will aim to maximize return while minimizing risk. For a passive strategy it is useful to choose diversified funds that have minimal overlap in their holdings. It is a common mistake for new investors to select several funds, thinking they are creating diversification, but fail to notice many of the same stocks are held in all. Selecting funds with low expense ratios can help limit overall costs and is another key factor.

Here is an example of a basic ETF portfolio using Vanguard funds for someone with a long investment horizon. These 4 funds hold over 17,000 stocks in total and have an overall expense ratio of 0.06% assuming the provided weight percentages are used.

Path 1 is heavily concentrated in large U.S. companies. Path 2 provides exposure to U.S. large and small, international, and developing market companies. Holding different asset classes smooths out returns as the classes tend to perform differently over periods of time.

3. Start a recurring investment into your selected funds on a biweekly or monthly basis. This typically needs to be done after an initial investment has been entered.

If you have $500 to invest and are using the provided weights from the chart, take $500 and multiply it by the weight to determine how much to invest in each fund. If you chose to invest in VTI, $500 x 0.30 will result in you investing $150 of your total $500 in that fund. If you decide to use a different weight system, make sure they add up to 100%.

Determining how much to invest is a subjective matter and will be different for everyone. If this is the only location you invest, start with 10-30% of your paycheck into the funds and see if that works for you. Be advised that selling these funds will likely be taxed. If you have a need for the money within the next year, the stock market is likely not where you should store your dollars.

4. Over time, your portfolio will drift away from these predetermined investment weights. Recurring investment amounts can be altered to rebalance your portfolio.

Rebalancing Example

After the first year of investing $500 every two weeks into our example portfolio, market fluctuation may have your account looking something like this.

Excel formulas, using VTI row for reference:

% of Portfolio = (VTI $) ÷ (total portfolio $)

Drift % = (VTI % of portfolio) – (VTI Target Weight)

Drift $ = (VTI Drift %) x (VTI $)

A drift of over or under a certain threshold should be addressed, 5% is used here. This example shows VTI has risen above its target and VXUS has fallen below. A simple way to solve this issue is to allocate some of VTI’s next investment to VXUS to rebalance them back into tolerance. You can pause or cancel your current recurring investment and restart it after you make this correction. Rebalancing doesn’t necessarily need to be done every time you invest. Doing it quarterly or semiannually is suitable for most people. Most platforms will not show your personal drift preferences, you will likely need to build out your portfolio in an Excel spreadsheet. The needed formulas are provided above.

5. Enable dividend reinvestment so cash will be placed back into the funds, otherwise cash will pile up and sit dormant in the account.

Debrief

This can be a large undertaking for a new investor. The most important things to remember:

• Do your own due diligence with where your money is going.

• Be aware there will likely be great deals of fluctuation on the path to long-term growth.

• Stick to a plan you can be consistent with.

Don’t attempt to bog yourself down in things you do not understand. Simple is often better because it can be followed with fewer obstacles in your way.

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