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Investment Strategies I – Index Investing





With the markets making a rebound, there’s a lot of talk about investment strategy.  In particular, passive and active investment strategies.  This is more of a beginner investor article so hopefully the more experienced investor readers out there can add to the comments.

To start, lets go over what passive investing actually means.

Passive/Index Investing

Passive investing is perhaps the investment style that is most popular among personal finance bloggers.  This is where you buy and hold a basket of indices (via index ETF or mutual funds) for the long term.  Every so often when new money is added, the portfolio is rebalanced to the appropriate asset allocation to the investor.

What is an index? An index, like the S&P500, DJIA or TSX are a group of stocks chosen to represent portions of the stock market.  The weighting of the index is typically adjusted by the market capitalization of the underlying securities.  In other words, if a large company on the index increases in value, it will represent more of the index.

Index mutual funds and ETFs basically mimic the index by buying the same basket of stocks at corresponding proportions and adjust accordingly.  The reason why index ETF’s/mutual funds can keep their fees (MERs) lower is because normally the buying/selling is done automatically by computer and not an active fund manager.

There are many benefits of passive investing, some of which include:

  • It’s relatively easy and takes very little time.
  • Betting on the index beats an active mutual fund the majority of the time.
  • Indexing costs a lot less than active investing, thus increasing returns over the long run.
  • It takes the emotion (thus mistakes) out of investing.

A popular index investing strategy is the global couch potato strategy where the portfolio is split into 4 parts.  Each part of the portfolio consists of an index.  This includes a Canadian Index, US Index, International Index, and Canadian Bond index.  As you can see, this type of portfolio will give ample equity diversification along with a portion for bonds.  The percentage of equity/bonds really depends on your risk tolerance.  The lower your risk tolerance for volatility, the higher your bond allocation.  However, over the long term, the higher the bond allocation the lower your portfolio returns.

You can view my example of a low cost index ETF portfolio here.  As well, below are some additional ETF’s that you can look into:

Tomorrow, we’ll discuss some active investing strategies.  Stay tuned!





19 Comments, Comment or Ping

  1. 1. Kathryn

    I’m a huge fan of passive investing. We’ve been couch potato investors for years. We’ve been highly influenced by the moneysense couch potato investment ideas.

    http://www.canadianbusiness.com/my_money/investing/article.jsp?content=20060405_152254_1452&?ref=ln

  2. That’s an interesting strategy. However what happens when you enter stagflation where the economy drags stock markets down, while experiencing a high level of inflation? You need TIPs.. That’s something I need to work on in my portfolio as well however..

  3. 3. Kasm

    Great Thread – Given the current economic situation, is now a good time to start up a passive portfolio? or given the nature of passive investing, it doesn’t really matter.

    Those who do passive investing, is 100% of your portolio passive or is it less?

    One more question – Are there recommendations on a discount broker for this strategy. I’m looking at rebalancing 4 indexes with contributions twice a year. (8 transactions annually) – starting off with about $50K with similar contributions annually.

  4. I’m a bit upset, you didn’t mention the Sleepy Portfolios ;)

    Personally, I’m a huge advocate and follower of a passive investing strategy. The reasoning is simple: most investors do not even make market averages. They can easily close the gap with what they are earning and what they could have earned using a passive approach.

    @Kasm: I’m about 80% indexed. The rest is in stocks and mutual funds (long story but it is in a group RRSP).

  5. 5. cannon_fodder

    Kasm,

    I’d check out Interactive Brokers but make sure you understand if you’d be subject to any minimum monthly fees. I believe you need to generate about $10 worth or you will be dinged regardless.

    If you’d like to stick to mutual funds which replicate indices, the TD e-series are well regarded. You would have to determine if they have something for every type of investment and global market that interests you.

  6. 6. Carl

    I am not sure I like this strategy. Following this, I would have made exactly $0 between April 2003 and now.

  7. 7. Jordan

    Carl, do you have an alternative strategy that made >$0 after taxes & expenses for that time period? Just because indexing didn’t make any money doesn’t mean the strategy is invalid. Every investment strategy has good and bad periods, and after a major drop like we’ve had I’m sure there are many strategies that did far worse then indexing.

  8. 8. Elbyron

    Carl,
    You’re looking at a 6-year period, but if you take a look at longer periods there has historically been pretty good returns using this strategy. When you examine how this strategy might have worked in the past, you not only have to consider longer terms, but also you have to look at more than just one particular period. Obviously if you bought in at a particular time when markets were strong and compare this to their current weakness, it doesn’t look so good. You could also pick a low starting point and compare to a high ending point, and say this strategy is fantastic. Neither is accurate because you have to consider all the possible periods when evaluating the success of a long term strategy.

  9. 9. M Hawk

    I’m 23 with little to no investment knowledge or experience. (Besides GIC’s in my RRSP) I’ve got some $$ that i’d like to invest.

    I like the idea of this system. Would this be an okay starting point for me, or would I be better off putting my money into a managed mutual fund and then building up my knowledge before attempting something like this? (I never trust the abilities of the people who try to sell me mutual funds though- hence why i’m looking for something i can learn about and do myself)

    For a very beginner investor, would this system be manageable?

  10. Kasm, I would say 40% of my RRSP is indexed with the proportion increasing over time. With regards to a discount broker, check out my discount brokerage comparison.

    Carl, you have to think longer term when it comes to equities. At least 10+ years. Here are some historic 10 and 20 years market returns since 1950.

    CC, you are right, I will include your sleepy portfolios in the article.

  11. M Hawk,

    If you are looking to invest small amounts at a time, I would suggest that you stick with low cost mutual funds. The favorite around here is the td e-series with MERs as low as some ETF’s.

    Check out this post on a diversified e-series portfolio.

  12. 12. Matt

    A good start for anyone interested in passive investing. My only addition for people without the time or interest in active investing is to make sure they re-balance bi-annually or annually. The only drawback to long-term passive investing is the Japan trap. Google Nikkei 225 and check out the Japanese market from 1989 until today. It is a roller coaster! There are those, myself included, who believe we are headed for a similar fate with US markets and European markets (Canada should be spared thanks to resources).

  13. While I believe in taking the emotion out of investing, anything passive with finance is dangerous. Investing is serious, and takes a lot of work. You better do your homework or you could lose big. Consider the stock market today. Some people are saying buy it because it’s at a huge discount when recovery happens. Will it happen? Consider our debt, and the massive devaluing of the dollar. How long until you’ll see a return or even break even.

    Don’t take investing lightly folks. Great article!

  14. FT: I was pulling your leg ;) The mention is appreciated nonetheless.

    @Carl: It is true that there will be periods when simply buying-and-holding is a losing strategy. But if the average is zero, you have to make sure that you don’t do worse first. A lot of investors, unfortunately, fall short.

  15. 15. Sampson

    @ Sexy Finance,

    I don’t think the ‘passive’ means you should take a passive approach to your asset allocation and finances in general, only that for most people, investing in indexed funds will likely outperform picking individual stocks to buy and hold.

    Whether you pick individual stocks or invest in index tracking funds you should be ‘actively’ re-balancing your portfolio on an annual or semi-annual basis.

    Regarding whether the investing in an index tracking fund would have produced any positive returns – there are two pieces in the discussion missing – dividends are not included, and the real question is not if the index gave a positive return, but whether it beat a portfolio of stocks you would have picked in 2003.

  16. 16. julie

    Great article!!

    I’m with @sexy finance. While I know what is meant by passive investing – I’ve learned that the “label becomes the experience”. Being in pursuit of “passive income” can create a mindset of doing the least to get the most. That can really backfire … it doesn’t mean you have to spend hours and hours on your investments. But, it does mean you are actively monitoring and controlling them. With real estate – I now refer to it as positive cashflow or leveraged income. I don’t call the money we make each month passive income. Semantics to some – but it’s been an important lesson for me.

  17. 17. Neil

    One of the problems with active investment strategies (if you are doing them yourself) is that you can never take your eye off the ball.

    I’m a big fan of the passive method!

  18. I use passive investing in the form of the US and International TD e-Series funds, within an RRSP. Simple way to get my non-Canadian exposure without worrying about picking stocks or what the tax implications are.

  19. 19. finance

    Passive investing is really for us. Perhaps if others also may join in this indexing it could boom more.

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