How to Set Up a Passive Investing Portfolio

In  his seminal work–the Intelligent Investor–Ben Graham describes two types of investors. These two types he classifies as “Defensive” and “Enterprising” investors. To break these down, you can consider defensive investors as more passive and risk-adverse. On the other hand, enterprising investors don’t mind being a little bit more risky in their investments. Last week we discussed dollar cost averaging. This is a great tool to lead into our discussion this week of passive investing.

Passive Investing

When I first read Graham’s writing about defensive investing, I wondered how investing could be passive. After I finished the book I did some of my own research. I learned that passive investing can actually be one of the most effective methods of investing.

Passive investing is such a great tool that it almost sounds too good to be true. With modern technology and online banking, you can literally automate everything. Ideally, you leave your portfolio for 30-40 years until you’re ready to retire.

Obviously, there is a little bit more housekeeping than that. Usually, passive investors will rebalance their portfolio anywhere from 2-4 times per year. Rebalancing is important, as it dictates your allocation of stocks, bonds, and other investments you hold.

Generally speaking, younger investors will have a higher allocation of stocks and bonds because of their tolerance for risk. Rebalancing should occur when excessive action in the stock market changes your allocation. For instance, if you have a 50/50 allocation of stocks and bonds but stock prices rise substantially, it could skew to 60/40. During one of your check-ups, you can rebalance accordingly.

Passive Investing With Stocks and Bonds

Many people like to own individual, blue chip stocks for their passive portfolio. These stocks don’t generally fluctuate a lot in price but carry high dividends and are less risky than growth stocks. American blue chip stocks include companies like Wal-Mart and McDonald’s. These companies have a durable competitive advantage and are well-established brands. If you want to go the blue chip route, make sure you look for high dividends. Generally, I wouldn’t recommend buying if the dividend yield is under 3%.

Personally, I believe that an ETF strategy is the most passive and least risky technique for passive investing. An ETF is an exchange-trade-fund. Exchange-trade-funds operate similar to stocks in that you can buy them on the stock exchange. However, instead of being a single company, an ETF is a fund made up of many companies.

ETFs are great because they provide diversification by simply purchasing a fund. For instance, buying an S&P 500 fund will allow you to own the 500 largest US stocks in one place. Likewise, there are various funds that own large Canadian stocks.

As for bonds, it can be difficult to purchase a diverse set of bonds if you don’t have hundreds of thousands of dollars in the bank. Like stocks, you can also purchase bond ETFs that can help you mitigate this issue.

When buying ETFs–stocks or bonds–I would recommend doing so through a Questrade account. Questrade offers commission-free ETF purchases, with minor ECN fees.

Things to Watch Out For When Buying ETFS

The reason why I like ETFs instead of Mutual Funds is that they have far lower fees. However, some ETFs have higher fees than others. This means that you need to look at the MER of an ETF before you purchase. Many companies have similar funds, such as an S&P 500 fund, that will operate almost identical. In this case, make sure you’re buying the ETF with a lower MER.

Another thing to watch out for when buying ETFs is that you do not over-diversify. How does this happen? Well, diversification is great but sometimes you get what is called fund overlap. Basically, this means that you own multiple funds that have overlapping companies. Fund overlap is why it can be a bad idea to own multiple funds of the same index.

Think of this example. You own an S&P 500 fund, an index that tracks the 500 largest stocks in the US. You decide you want more diversification so you purchase a total-market US fund. By doing this, you are almost certainly creating fund overlap, unnecessarily limiting your funds.

Setting up a Passive Investing Strategy

With modern technology, almost everything can be automated. Therefore, the best way to set up your passive investing portfolio is to set up automatic direct deposit into your investment account from each paycheck. By doing this automatically, you won’t be thinking about what else you can do with the money. Instead, it will just be deposited into your investing account.

Once this is done, I would recommend contributing to ETFs every quarter to dollar cost average them. By doing this, you will get the best average price of the ETF while growing your investments. This is also a good time to rebalance your portfolio.

Passive investing is ideal for people who don’t want to spend the time researching individual stocks. It is also great for people who lack the discipline to watch their investments tank and stay strong. By having index-based ETFs, it is easier to see one’s portfolio value drop as it coincides with the market.

If you are interested in purchasing ETFs and want to set up an account with Questrade to get commission-free purchases, check out our blog post that has a step-by-step guide. If you’re curious about what to look for in individual stocks, sign up to our Insider’s List below and get a free cheat sheet!

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