Passive Investing Strategies for This Market

Posted on October 22, 2012 at 12:21 PM PDT by

Passive investing strategies are all about following the market leaders, right? Not really. Sometimes, it means you are ahead of the market by a wide margin.

Consider how passive investing strategies would have served a typical investor over the past few years. Any number of normal investment measures, such as the market P/E ratio, would have told you to sell your equities positions.

Yet passive investing strategies are never about selling it all on the spot. Instead, they offer a chance to ride the flukes that can happen, then sell portions of those gains as they distort your target allocations.

passive investing strategies

For instance, imagine a passive investment allocation that calls for about 45% U.S. stocks, around 15% bonds, 17% foreign developed stocks, perhaps 7% emerging markets, and a smattering of TIPs and commodities for good measure.

If you took the S&P 500 to be your measure for U.S. stocks, your total return over the past three years comes to 36%. On price alone (not counting dividends you might have reinvested), the Vanguard Total Stock Market ETF (VTI) is up 32%. A position in Vanguard Total Bond Market ETF (BND) is up just over 7%, again taking the dividends as cash.

Common sense says that both of these trends cannot be sustained forever. Generally, bonds and stocks move against each other over time. But should you really dump your stock holdings now? And are bonds a safe place to “hide out” in the meantime?

Consider this piece of advice from money manager Laszlo Birinyi, reported by Bloomberg News:

The bull market will last another year as individuals regain confidence and return to equities after withdrawing money since 2007, according to Laszlo Birinyi, the president of Birinyi Associates Inc. in Westport, Connecticut. Investors have pulled about $100 billion from U.S. stock funds this year and added $250 billion to bond funds, according to data from the Investment Company Institute in Washington.

“I don’t think you’ve seen the signs of a frothy, toppy market,” Birinyi, who traded equities at Salomon Brothers Inc. in the 1980s, said in an Oct. 17 phone interview. “People are realizing that the stock market is not all that bad. It’s been telling us that the economy and companies are in better shape than people think.”

It’s a sobering thought. While stocks have appreciated dramatically in the short run, and everyone seems to believe that our unusual monetary situation is the reason, a major-league strategist is warning not to abandon blue chips just yet.

Passive investing strategies come into play

The really crazy part of trying to time any market is “guessing right” the next major move. Some people can do it, in theory. But you could count on one hand those folks, and even they eventually fall victim to senseless market swings.

Nevertheless, passive investing strategies can help you have your cake and eat it, too. Very likely, over the past three years that 32% return on stocks would prompted you to sell off a portion of your S&P 500 holding.

That choice, along with the incoming dividends, means passive investing strategies would have generated cash for reinvestment. During the same three-year period, for instance, Vanguard MSCI Emerging Markets ETF (VWO) is up just 4%. Vanguard’s International Small Cap ETF (VSS) is up just about 5.5%.

These funds in your portfolio’s asset allocation would now represent a lower percentage of your target and, thus, be on your “buy” list in a periodic rebalancing scheme along with, possibly, bonds.

In effect, passive investing strategies take the emotions out of the matter. You regularly and programmatically sell your gainers and buy the slower-moving asset classes. If Birinyi is right and U.S. stocks move higher, you’re still in that part of the market in a major way. If he’s wrong and things decline from here, you’ve locked away some of the gains in advance.

The one thing that is absolutely going to happen is that the global herd of investment capital will move — sometimes violently, sometimes at an agonizing pace. Being in the right place at the right time is less of an imperative if you can manage, cheaply and efficiently, to be in all the right places at all times.