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Passive Investing, Actively

Index funds, which track the entire market or portions of it, do best for investors over time. These funds are called passively managed, because their components get selected automatically, according to index movements. But you shouldn’t be passive about managing them. You must be very active.

A fundamental principle I preach is that having a core of passively managed mutual funds is the foundation of successful long-term wealth building. I practice that principle, as well: About 75% of the securities in my personal portfolio are passively selected.

My commitment to this approach has evolved both from my own years of investing experience and from reading reams of research. I’m convinced that beating the market over the long term is as elusive a goal as capturing a wild jackalope. Last year, 86% of large-stock active funds failed to be the Standard & Poor’s 500.

Does that mean investing is as simple as giving most of your money to passive managers and kicking back? Not quite. Yes, investing in the index funds of a diversified group of asset classes, and leaving them alone, is a good fundamental strategy that helps you secure your financial future. To be even more successful, however, it helps to apply some additional strategies.

Bob Seawright of Madison Avenue Securities in San Diego had a terrific blog post that reminded me of this. Here, inspired by and adapted from his top 10 list, are some of the factors that strongly affect the success of passive investors. While financial professionals can help with all these strategies, investors going it alone can also benefit from paying attention to them.

1. What’s the point? A successful investment strategy starts with establishing clear, objective, and realistic goals. Most people bypass this step, thinking it is unrelated to their investment selection. Yet on their deathbeds, very few focus on how great it was to get a 7% annual investment return. Drilling down to what is really important in your life is no simple task, but it is essential. Creating a life worth living means using portfolio returns to support your dreams and desires. Knowing where you are going and why is the first step to establishing a successful portfolio.

2. A written investment plan. Yes, you need your investment strategy in writing. This both ensures that you have one and helps you clarify it. I find that writing things down often helps me find gaps and inconsistencies in what I thought was a complete and rational plan.

A written investment plan should state:

a.) Your investment philosophy. Are you a passive or active investor, or both?
b.) Your goals and objectives for your funds. This answers the question, How and when will this money support my life?
c.) Guidelines and constraints you adhere to in managing your money. How long should your fund manager have held the job, what is your upper limit on fund expense ratios, how much flexibility do you give a manager, what quantifiable factors take you out of a market or bring you back in?

A written plan brings structure and discipline to your investment strategy, qualities that most investors lack.

3. Manage your behavior. We all have blind spots, biases and delusions. How you behave in the face of market declines and advances affects your long-term portfolio returns more than any other single factor. To make this even more challenging, your brain is naturally wired for investment failure. Identifying and reframing your behavior with money can help you rewire your brain for success instead. Working with a financial coach or therapist can be invaluable to help you negotiate your own mind.

4. Financial planning. Many people think financial planning is limited to investment advice. Yet it is much broader and deeper. Financial planning helps you build wealth and use it wisely to support the life you want.

My next article will cover six more keys to successful passive investing.

Categories: The Market

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