16 Oct Passive Investing Done Right
As I mentioned in my earlier blog “Invest Better: Active vs. Passive Strategies,” new investors have an early choice to make. Should they invest actively to try and earn higher returns or passively to try and reduce fees? If you’ve made the decision to invest passively, you may be tempted to hire a financial advisor to help navigate a sometimes confusing investment environment. But our advice would be to save your money. While many advisors can make investing seem complicated, the truth is that passive investing is fairly simple, if you know the basics. And there are lots of free online tools to help you along the way. In this blog post I’ll walk you through the basics of passive investing and teach you how to manage your portfolio with ease.
First, you’ll need to determine your risk tolerance. In other words, how much variability in investment returns are you willing to put up with? For example, if the value of your portfolio dropped by 30%, would you get nervous and sell your stocks or would you be able to stay the course? Your risk tolerance is important because it will be used to determine the proper asset allocation (i.e., the mix of safer investments and riskier investments) for your portfolio. There are typically five categories of risk tolerance: 1) very conservative, 2) moderately conservative, 3) moderate, 4) moderately aggressive, and 5) very aggressive. There are a number of free risk tolerance questionnaires online that can help you determine which category fits you best. But in general, very aggressive investors have:
a) A long time before planning to withdraw funds from their account (typically 20 years or more)
b) A strong desire to achieve above-average returns
c) A willingness to lose some or all of their investment in exchange for greater potential returns
In contrast, very conservative investors have:
a) A short time before planning to withdraw funds from their account (typically 5 years or less)
b) A strong desire to preserve, rather than grow their wealth
c) A preference for portfolio stability
And moderately conservative, moderate, and moderately aggressive investors fall somewhere in between. Once you have determined where you fit along the risk tolerance spectrum, it is time to determine your proper asset allocation. Although there is no hard and fast rule for how much to invest in each asset class, a good guideline from Charles Schwab is shown below:
As you can see, the more risk tolerance you have the higher the portion of stocks (i.e., equities) you’ll want to have in your portfolio. And the less risk tolerance you have, the higher the portion of bonds (i.e., fixed income).
Now that you have decided where you fit along the risk tolerance spectrum and determined your asset allocation, it is time to open a brokerage account. A brokerage account is basically like a checking or savings account that allows you to buy and sell stocks, bonds, and mutual funds. But instead of opening an account at a bank, you will need to open an account with a brokerage firm. There are a lot to choose from including Charles Schwab, Robinhood, E*Trade, and Fidelity. But if you choose to sign up with one of these brokers, you will be on your own for finding investments in each asset class and managing the allocations. But have no fear, because we have put together a list of inexpensive funds you can buy to help you meet your targets:
If your broker does not offer the funds listed above, you can generally purchase similar funds from Vanguard, Charles Schwab, or iShares. A simple Google search should provide the ticker symbol you will need to make the purchase. Just make sure to find one with a low expense ratio in order to minimize the fees you will have to pay.
If the idea of finding investments and managing your asset allocation is still overwhelming to you, we recommend opening an account through the Acorns app, which you can download from your iOS or Android Phone. For just $3 per month, Acorns will help you determine your risk tolerance, invest in the proper asset allocation, and rebalance your portfolio as needed. It is simple to use, inexpensive, and takes the hassle out of passive investing.
But we also understand that some people don’t want to hand over complete control of their portfolio. They like having the freedom to buy and sell individual stocks that interest them. For those investors, we recommend opening an account through the Robinhood app. With Robinhood, buying and selling stocks is simple and easy and best of all there are no transaction fees. However, our recommendation would be to have Acorns manage most of your portfolio (say 80% – 90%) and only put a small portion into Robinhood (say 10% – 20%). Why? Because successfully investing in the stock market is difficult, even for professionals. Therefore, for most people, picking individual stocks is likely to lead to suboptimal returns over the long-term.
And that is it. You now have the tools to invest passively, without the need for an expensive advisor. If you’re ready to start investing on your own but would like further guidance, feel free to email me at firstname.lastname@example.org.