How to Invest Passively

Stocks and bonds are time honored investments that rise in value over long periods of time, at least 10-20 years. If you want to invest, but lack the time to do invest actively by selecting individual stocks and bonds, you can invest passively using index funds such as buying shares of Exchange Traded Funds (ETFs) to obtain market return. While passive index investing will not beat the market, you will not underperform the market either. Obtaining market return consistently is actually quite satisfactory, considering that approximately 80% of mutual funds underperform the stock market's returns every year.[1]

Steps

1. Determine your asset allocation. A rule of thumb is 100 minus Your Age equals the percentage of your investment that should be in stocks, and the rest should be in bonds. For example, if you are 30 years old, you should have 70% stocks and 30% bonds.
   
   • According to Benjamin Graham, the percentage of stocks should be at least 25% and at most 75%, and likewise for bonds, to provide good diversification. So if you are under 25, you should have 75% stocks and 25% bonds. And if you are over 75, you should have 25% stocks and 75% bonds.
2. Determine the allocation for your stocks. A simple way is to pick a well-diversified, low expense index fund or ETF that provides broad market coverage, such as Vanguard Total Stock Market ETF, which tracks the investment return of the overall stock market, with a low expense ratio of 0.07%. Expense ratio is the percentage of your investment that a mutual fund or ETF charges annually for managing your money. For example, if you invest $1000 in a fund with 0.07% expense ratio, you lose $0.70 per year to management fees. This fee is automatically deducted from the share price of the fund. Thus, the lower the expense ratio, the better the long term return of the fund. Look for other index stock funds or ETFs by searching online for ETF or mutual fund screener.
   
   • To diversify among your stock allocation, you can, for example, allocate 50% for US stocks, and 50% for foreign stocks. Since the US and foreign markets may move differently, rebalancing will help you take advantage of buying low and selling high in each market.
3. Determine the allocation for your bonds. The easiest way is to allocate 100% of the bond portion to a single total bond index fund or ETF, that has the highest yield and lowest expense ratio. For example, Vanguard Total Bond Market ETF has relatively low expense ratio of 0.12%. Look for alternative bond index funds by searching online for a ETF or mutual fund screener.
4. Open a stock brokerage account and buy the index funds or ETFs as you allocated. For example, suppose you have $10000 to invest. If you are 50 years old, allocate 50% stocks and 50% bonds. You can spend $5000 to buy a broad stock market index fund or ETF, and $5000 to buy a broad bond market index fund or ETF.
5. Rebalance regularly: monthly, quarterly, semiannually, or annually, depending on your preference. Rebalancing allows you to maintain the same allocation and forces you to buy low and sell high. It is also a good time to add money to your investments. Use dollar cost averaging by adding a set amount to your account at regular intervals, so that you buy fewer shares when prices are high and buy more shares when prices are low.
   
   • Suppose that decide to rebalance quarterly and you can add $1000 to your account quarterly so that you start with $5000 in a stock index fund and $5000 in a bond index fund. Three months later, suppose stocks have risen while bonds have remained unchanged, so that the portion of stocks is now worth $6000 and the portion of bonds is now worth $5000. Stocks now make up 55% of your portfolio and bonds only 45%. To reestablish the same 50/50 allocation, and adding in the $1000 to the portfolio value for a total value of $12000, you will need $6000 in stocks and $6000 in bonds, so you hold the stock index fund, and use all $1000 new money to buy more of the bond index fund.
6. Keep your risks in check by that simple rebalancing program: acquiring more assets that are relatively cheap but fewer assets that have been rising and becoming high priced, and certainly selling your shares when they become too dear. Keeping them would become a luxury (in the example given, if stocks had risen even more than that, you would be "selling high" to buy bonds).

Tips

• Be patient and stick to this plan. Have a long term perspective and your portfolio will grow with minimal effort on your part.
• Passive investing through index funds will minimize risks associated with individual stocks and bonds. Since each stock or bond account for a very small portion of a well-diversified index fund, any particular stock going bankrupt or bond defaulting will have negligible effect on the index fund as a whole.
• Pay no attention to stock market news, which tend to promote buyer excitement that leads to buying when stocks have gone up, and then downheartedly selling when stocks have gone down. That is inverse to your goal of buying low and selling high -- and the surest way to lose money.

Warnings

• Watch out for fees associated with mutual funds. High fees will significantly reduce your returns after compounding. Index funds tend to have the lowest fees overall (typically between 0.07 to 0.2 percent), while actively managed funds tend to have high fees in excess of 1%. In addition, look for funds with the lowest annual turnover. Annual turnover is the percent of its holdings that are replaced each year. For example, a fund with 100% annual turnover replaces all its holdings in 1 year, while a fund with 5% annual turnover replaces only 5% of its holding in 1 year, or all of its holdings in 20 years. Higher turnover rates will incur more capital gains taxes and diminish long-term returns. Look for index funds with the lowest expense ratio and annual turnover, which will win in the long term.

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