Passive Investment Portfolio Basics: 3 Questions

Posted on September 11, 2012 at 9:00 AM PDT by

Building an effective passive investment portfolio is a mind game, much more so than you might think.

Consider these three simple questions: What do you believe about investing?

  • That, over time, stocks will outperform bonds?
  • That long-term investing is better than short-term?
  • That, as time passes, the impact from market headlines will diminish?

If you agree with these ideas, you’re ahead of the game when it comes to building an effective passive investment portfolio. Your thoughts are already in line with most professional money managers, according to a survey conducted by Pensions & Investments and Oxford University.

passive investment portfolio basics

Here’s another way you probably agree with the professionals: It’s far easier to pick assets than it is to understand the risks underlying them.

In the study, about 30% of respondents were neutral to the idea that “diversification across risk premiums, rather than across asset classes, generates superior risk-adjusted returns.” Fifteen percent said they didn’t know.

That means that close to half (45%) of professional money managers surveyed are unlikely to take the time to plumb the risk-reward relationship of a given investment strategy. It’s too much work.

“Asset classes are easy to identify, you can tell debt from equity. But actually being able to identify one risk premium to the next is much more difficult. It’s definitely the more difficult route, but it’s also potentially more rewarding,” Dane Rook, an Oxford researcher who studied the results, told Pensions & Investments.

Nevertheless, most who used them agreed that risk-based strategies worked: Fifty-two percent reported that the risk-adjusted approach met its expected return, and 38% reported outperformance.

Consider the gap here: Forty-five percent believe that risk-adjusted investing is more trouble than its worth, yet most reported an expected or better-than-expected return from using it.

The takeaway for your passive investment portfolio is simple enough: In investing, you can trust a person, an institution, or a process. Only one can be tested with rigor.

Passive investment portfolio in action

Trusting a person can be very reassuring. Your investment advisor ends up being nearly family over the years. Nevertheless, if he or she truly has your back, you can bet that risk-adjusted, passive investing is a major part of the plan.

If instead you trust an institution, say a big brokerage or bank, then you are one step removed from the people who make the decisions about your money. Advisors come and go with their pay and prestige.

Finally, there’s process. Truly risk-adjusted investing is not that hard to do. It can be replicated with software and it is easy to follow and test. It’s cheap and it works. You can learn passive investing in a weekend and put it into practice in a few hours.