5. Asset allocation. This is critical. Study after study shows the most important determinate in your overall investment success isn’t picking the right stocks, bonds, or real estate. According to one researcher, a good asset allocation strategy can add about 0.5% to your long-term return. It’s your overall mix of various asset classes that will ultimately have the greatest impact on your success or failure. Investing your entire 401(k) in several stock index funds can be as insane as putting everything into bond funds. Even a mix of stocks and bonds, while better, can leave a portfolio over-exposed to the fortunes of one sector and exposed to the failing of one country’s economy.
6. Manager and index selection. Especially if you are over 40 and have retirement in sight, successful passive investing isn’t quite as easy as calling Vanguard and putting everything in an S&P 500 index fund. Every asset class has multiple indexes, with managers who all have their differences in philosophy, execution, and fees. Some adhere to traditional indexes while others build their own indexes based on their research. Picking the right index with the right manager can add up to 2% over the long haul to the annual return generated by a good asset allocation.
7. Rebalancing. Once you set your target allocations, you need to periodically sell off the advancing asset classes to purchase more of the lagging classes. Suppose you want 30% of your portfolio in U.S. stocks and 30% in bonds. If stocks are doing well and bonds are not, over time you might end up with 35% stocks and 25% bonds. Selling stocks and buying bonds to rebalance the allocations is a disciplined form of “buy low and sell high.” Without it, your portfolio will miss out on some extra returns and over time take on more risk and volatility. Research shows that periodic rebalancing can add 0.5% to 1.5% annually over the long term.
8. Asset placement and taxes. Other adjustments need ongoing attention in any portfolio. Asset class location helps minimize tax consequences by matching the assets with the right account. IRA’s are best for certain asset classes, while Roth IRA’s do best with others and taxable accounts with still others. This matching can add up to 0.5% annually, so getting it right can be a big deal. It’s also important to tweak asset class allocations to adjust for long-term bear or bull markets, significant economic or tax policy changes, or changing personal situations. Another necessity is minimizing taxes by efficient and timely loss and gain harvesting.
9. Uncovering scams and ill-suited investments. Recently a client asked me about a start-up online business in which several of her friends had invested. While there were many things about it that concerned me, at the core this just wasn’t an investment opportunity that suited my client’s expertise, goals, or risk tolerance. I strongly urged her to pass, and she did. Within six months the offering was found to be a well-pitched scam, and everyone who invested lost their money. Having someone to help investigate the legitimacy of investment ideas can always be helpful.
10. Keeping it sensibly simple. Keeping things simple for simplicity’s sake doesn’t always produce the desired benefits. While it’s simple to put your whole portfolio into one stock or one mutual fund, the results could end up adding layers of complexity to your life. The right amount of sensible complexity can turn a good passive investing strategy into a highly successful one.