Beginning Investors, Passive Investing |

Passive investing is intellectually appealing to the investor willing to shun Wall Street propaganda and hype from a 200 billion dollar industry.? Just to be clear, we concede there are, and will be, active money managers who outperform their benchmark.? However, as the years go by the winners dwindle in number and it is very difficult to select which managers will be successful thirty or forty years from now.? Try identifying the next Warren Buffett, Michael Price, Max Hein or Charlie Munger.? What actively managed mutual fund will best the market index over the next ten years?? The probability of selecting the top performing funds is extremely remote.? Mathematically, it makes sense to take the index route to portfolio construction.

So you are going to manage your own portfolio through stock selection (not encouraged).? If this is the investment path of choice, here are a few guidelines to keep in mind.

• Establish a benchmark that is appropriate for your portfolio.? If you are investing in small-cap stocks, don't use the S&P 500 as it is an inappropriate benchmark.? The S&P 500 has unfortunately become the default benchmark for nearly all portfolios.? If your portfolio holds a significant percentage in bonds, and that may well be appropriate for your situation, the S&P 500 is not the standard to use.
• Know how to accurately calculate the Internal Rate of Return (IRR) for both the portfolio and benchmark.
• Set up an appropriate benchmark for your portfolio.
• Know what risk is involved in the portfolio makeup and measure it accurately.? Use a semi-variance measurement model instead of the standard mean-variance model.

Individuals who do not measure the performance of their portfolio and benchmark are engaged in self-deception as they don't have a clue how well they are doing.? "You can't manage what you don't measure."

The Five-Step Process to Passive Investing

1. Lay out an investment plan.
   • The portfolio has an objective.? Is this a college fund portfolio or is it set up for retirement?? Think through the circumstances for which this portfolio is designed.
2. Select the asset classes.
   • The maximum number I use is seventeen including cash.? At a minimum include; U.S. Equities, Developed International Markets, Emerging Markets, Domestic REITs, and Domestic Bonds.? Then considering adding Commodities, International REITs, and International Bonds.
     
3. Determine the percentage to invest in each asset class.
   • As mentioned many times on this blog, this is the most difficult decision of investing.? No plan fits all investors so build your own customized portfolio to fit your situation.? There are many asset allocation plans provided on this blog.? Pick one that seems to best fit your situation knowing you can adjust later.? Read William J. Bernstein and others to pick up additional ideas.? Continue to adjust the asset allocation to fit your personal situation.? This ties back to step number one above.
4. Choose index funds or non-managed index ETFs to populate the asset classes.
   • My preference is to use index ETFs as they are tax efficient and 101 are commission free to TD Ameritrade clients.? Commission free ETFs are of great benefit to investors starting out with very small initial investments.? It becomes easier to build a well diversified portfolio at no cost other than money you saved.
5. Monitor the portfolio.
   • Search this blog for benchmarks or benchmarking portfolio.? There is a category for benchmarking so read those posts.? While somewhat time consuming, portfolio monitoring is essential if you are serious about investing.

Keep tracking ITA Wealth Management to see how different portfolios are managed.? Platinum members have access to eight portfolios where all the transactions are available.? These five steps will launch you on the path to passive-index investing.? Become a rational thinker rather than an ego driven investor.

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