Active Decisions in a Passive Investing World
The movement to low-cost, passive investing is real, as evidenced by the billions of assets flowing from funds attempting to actively beat their benchmark, to those vehicles that recognize the near implausibility of such a feat and simply work to track their respective benchmark. This secular shift is being driven by a handful of factors, including that young professionals are inherently skeptical of the active management industry’s claims of outperformance given their dismal track record of delivering anything close to what has been promised—particularly as of late.
On the surface, however, what the shift to index investing fails to miss is that even in using low-cost, passive investments, investing continues to be anything but passive. In fact, the word passive itself has a connotation of laziness associated with it, so much so that one of the common synonyms for the word is actually lifeless. Passive investing, despite its name, still involves a number of active decisions, and remains anything but lifeless.
In the passive world of investing, the active decisions focus more on things that can be controlled—such as our behavior, controlling costs—and a lot less on things we, and the smartest among us, have little to no control over—picking securities based on what the market will do tomorrow, next quarter, or even next year.
What follows is a brief breakdown of the critically important active decisions that passive investors must make. Young professionals who can, whether individually or with the help of professional guidance, make quality active decisions in these four areas stand to position themselves for success well into the future.
Read More: The Young Professionals Guide to Investing
Active Decision #1: Determining Your Asset Allocation
The sage advice, “the best investment is the one you are most likely to stick with,” ties in large part to passive investors first, and arguably their biggest, active decision: determining how big of a roller coaster to step foot on. Do you get onto the roller coaster that’s turbocharged with 100% stocks? Or are you better suited for a milder paced ride built with 50% stock and 50% bond?
What many investors fail to realize is how important this initial decision is long-term. It’s easy to want to be on the turbocharged coaster when skies are blue. Who wouldn’t want to get onto the coaster that has returned 12% annualized over the last five years, when the tamer one has returned a measly 5%?
The point, however, is to recognize that determining the appropriate roller coaster—asset allocation— for you and your specific goals upfront will have a profound impact on your ability to stay on the ride—investment—through 10%, 20% or even 30% declines and it is this ability that leads to profound, long-term success in investing.
The takeaway? Be deliberate when building your portfolio initially to align it with your individual risk tolerance (how big of a roller coaster can I stomach?), the time horizon for your goals (when do I need the money?), and your required return (how much do I need to make to achieve my goals?). And if you don’t feel confident in your ability to actively accomplish this, then find a fiduciary who can.
Active Decision #2: Deciding to Stay the Course, Over, and Over, and Over Again
Once you have crafted the appropriate portfolio with low-cost, index funds and an allocation aligned with your goals and objectives, it’s time to actively decide to stay the course—perpetually. Once again, this active decision seems, on the surface, so easy, and in good times it is. Who would want to actively switch up their portfolio when things are up 22% year-to-date!?!?!
If successful investing was easy, then everyone would do it, but unfortunately, it’s not, because it’s driven in large part by our ability to combat our own human emotion. For example, when 2008 occurred and stocks dropped by 50%, passive and active investors alike found themselves scrambling. Scrambling to do something. To take some sort of action, because in times of uncertainty it’s human nature to want to get active.
And yet as passive investors, it’s critical to make the active decision not to act. To stay put. To remain confident that we put ourselves on a roller coaster that we can handle, even when at the darkest point it might seem almost unbearable. Those who can actively make that decision, not to act, are the ones who get rewarded over the long-term.
Active Decision #3: Reviewing and Controlling Fees
There is a price war going on between Fidelity, Schwab, and many of the industry giants as they race to lower trading fees, costs on index funds, etc. And with that comes the active decision to constantly be monitoring the fees associated with your portfolio. Why is this important? Because research continues to support that controlling fees can have a profound impact on the long-term success of your portfolio.
In short, investors must make active decisions related to minimizing fees in their portfolio upfront, while also remaining cognizant of the secular trends that are continuing to drive down costs for investments across the board.
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Active Decision #4: Which Passive Investment Solutions to Use
Even for those investors that tend to favor a more index or passive approach, there are still no shortage of investment options to pick from. For example, there are currently hundreds of index funds to choose from, with each market segment (i.e. large company domestic stocks) having its very own handful of options to choose from. On top of that there are increasing options when it comes to automated investment platforms that help craft a low-cost portfolio on your behalf. These include, but are not limited to: Betterment, Wealthfront, Schwab Intelligent Portfolios, Fidelity Go, Vanguard, FutureAdvisor, the list goes on.
All of these options, whether made independently or with the support of an advisor, require an active decision about which solution is the best for you, your unique circumstances, and ultimately your goals. With anything in life, there are pros and cons and it’s important to be able to fully assess and make an active decision about which passive option is best for you long-term success.
Ultimately there are many active decisions that investors will continue to need to make, even as the industry and consumers shift more towards passive investing. Consumers and the advisors that serve them are not becoming more hands off, but rather being more focused on being hands on with those things that matter and can ultimately be controlled.
While we’ve outlined above four of the critical active decisions passive investors must continue to make, there remain an endless number that successful investing will demand moving forward. These include, but are not limited to: actively engaging in positioning passive investments within your portfolio for optimal tax consequences, actively determining the frequency of rebalancing your portfolio, actively determining if and when it can make sense to utilize some active investments, again, the list goes on.
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