In this post, I will share five passive investing strategies that could boost your long-term returns. There is nothing definite in investing, but applying these strategies will increase the chances of maximising your returns. This post will probably be the most powerful post in this blog. At the same time, it might feel like the simplest of all. While listing the five strategies, I will also explain why they will boost your returns and why they are a core part of a passive investing strategy. Ready? Let’s get started!
1- Only choose low-cost funds
I hope John Bogle will forgive me for using his sentence, but, as he does, I believe that costs matter. Watch out for the costs of your investments, as over time they will undermine you return dramatically.
Following the saying that goes “A picture is worth a thousand words”, just an example of how much costs matter, with the explanation in the text below.
Suppose you take a hypothetical investment of 10,000€ and you invest it in an index that gives an annual return of 8.5%. After 30 years, without investing anything else, you would have 115,582.52€. Yes, you are reading it correctly, you would have 115,582.52€ with an initial investment of 10,000€. That is the magic of compound interest and of long-term investment.
You will notice that I said hypothetical because to invest in an index you will need to do it through a fund, which always incurs in certain costs. These costs, however, can change dramatically and are the key point here. If we were to choose an index fund with an annual cost of 0.2%, the figure after 30 years would be 109,358.79€. That means that the investment company has taken 6,223.73€ while you gained 99,358.79€. A very good deal.
On the other hand, if you choose a fund that tracks the same index but with an annual cost of 1.5% (which is actually quite average for the industry), after 30 years you would end up with 76,122.55€. That means the investment company has taken 39,459.97€ while you gained 66,122.55€.
I will repeat it again because this is something you need to fully understand.
- 0.2% annual cost = 109,358.79€ for you and 6,223.73€ for the investment company.
- 1.5% annual cost = 76,122.55€ for you and 39,459.97€ for the investment company.
That means that with the second option, the investment company has taken 33,236.24€ that would otherwise be in your wallet (or bank account).
I will repeat it one last time:
33,236.24€ less for you
And this is assuming an investment of 10,000€. Imagine what would happen with your lifetime savings, which, if you save every month, will be much higher.
So yes, costs do matter. Always remember it. For more information and comparisons on how much do costs matter, I strongly recommend you read Common Sense on Mutual Funds by John Bogle.
2- Mathematical egg distribution (asset allocation)
This is another passive investing strategy I have taken from John Bogle. What I like about this strategy is that it removes the choice from the most important decision you need to take when investing and reduces it to a simple mathematical formula which takes into account your investment horizon. The mathematical formula goes as follows:
- Percentage of bond funds = Your age – 10
- Percentage of stock funds = 100 – Percentage in bond funds
If for example, you are 40 years old, your asset allocation would be as follows:
- Percentage of bond funds = 40 – 10 = 30
- Percentage of stock funds = 100 – 30 = 70
If you are 60 years old and close to retirement, it would be as follows:
- Percentage in bond funds = 60 – 10 = 50
- Percentage in stock funds = 100 – 50 = 50
This formula ensures that the closer you are to retirement, the more conservative your investment becomes. I think this is a brilliant formula because it is a very easy and simple one to remember. Moreover, it captures one of the essential principles of investing. The older you become, the more interested you are in not losing money (safety of capital) and less interested you are in earning even more money (maximising your returns).
Certain investing institutions have already created index funds that use this formula. They call them funds of funds, which basically means that the fund you are buying invests in other funds. So, depending on where you live, you might have these ones available to you. There are two types of these funds:
- Funds with a fixed percentage (allocation), for example, 80% stocks / 20% bonds. Vanguard offers this option under the name of Life Strategy Funds (UK information).
- Funds that target a retirement date and reduce over time your contribution into stocks (riskier) while increasing your contribution into bonds (less risky). Vanguard again has an option for you and they are called Target Retirement Fund (UK information).
One of the main advantages of these funds of funds is that you will be able to start contributing with even smaller amounts as you concentrate all your contributions into one fund. Another advantage is that you don’t need to worry about making sure your eggs stayed distributed proportionally, as the fund will automatically do that for you. Passiveness wins again!
3- Automate your contributions
You can use two different systems to achieve this.
The first system is called dollar cost averaging. This system is one of the most important passive investing tips. Basically, the idea is to buy a fixed amount of a specific investment on a regular basis, no matter the price. When you want to invest a big amount of money in the stock market, this strategy reduces the chance of buying all your stocks just before the market slumps.
Applied to passive investing, its underlying nature makes it the perfect ally. Following this strategy, you put your contributions into automatic mode. After you have decided which funds you want to invest in and which percentage you want to invest in each fund, you only need to transfer the money every month (or whatever period you have decided). This strategy ensures you don’t become a performance chaser, which is one of the most damaging and common strategies.
The second system is direct debit. Direct debit will take all the pain out of the process of buying and it will ensure you stick to the overall strategy when the market declines. As you may know, direct debit means that the specified amount will be transferred automatically at the time you specify. For example, if you decide you want to invest $500 every month in your funds, signing in for direct debit will ensure that this amount is transferred at your chosen date, no matter what the market is doing. This is an amazing way to ensure you stick to the plan, which you will be grateful you did at the end of the journey.
4- Don’t watch your investments (too often)
Because our brains are wired to be really attached to our money, we tend to panic with every small decline in our investments. Jason Zweig explains it amazingly well in his book Your Money and Your Brain.
You are better off leaving your investments to grow over time and focusing on other things instead. Some experts recommend checking your investments only once or twice a year, mainly for making sure your eggs are distributed as you laid out in your plan (this is called rebalancing). If you choose a fund of funds that does this for you, it wouldn’t even be necessary to check them apart from for tax purposes.
However, it would be naïve to think you will do that, as I struggle to do that myself. Therefore, I would recommend that you do what I do. Check them as often as you feel you need to check them, but every time you check them, remember that this is a long-term game and that the markets will always have periods where they will fall. The more familiar you become with investing, the easier it will be for you to stay longer without checking.
5- Stick to the four previous strategies no matter what happens
This is probably the most difficult strategy to follow, but it is also a crucial one to ensure that you maximise your returns. To successfully apply this strategy, you need to create a solid belief on the principles of passive investing and on the soundness of the four previous strategies.
You need to remember that passive investing is based on the underlying belief that the economy as a whole, on the long term, always grows. But, as nature, economy has its seasons. There are summers when the economy is buoyant and the market rises meteorically. But there are winters when the markets decline. And there are springs when businesses start flourishing again.
Following the metaphor, it could be useful to think of your investment as a tree. The same as the trees lose their leaves in winter and they might even lose a branch or two in a snow storm, your investment will decline in winter (falling) markets. However, your investment, as the trees, is strong and has its roots deeply embedded in the soil of economy. Therefore, you should keep it as you would keep the tree and in time it will flourish and grow again and you will be very glad you did not panic and sell.
I would recommend two books that will help you understand the cyclical nature of the economy. One is Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor. The second one is The Great Depression: A Diary by Benjamin Roth. They are not fun to read, but they will give you a perfect understanding of the nature of the economy. And, as the saying goes, those who ignore history are condemned to repeat it. So brace yourself and read them both. Your future self will pat you on the back when storms come.