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Passive approach

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Active approach

Passive approach


Introduction

The words "active" and "passive" are both meant in a good way, here. Taking a passive approach can be a very good decision, and when done right, it can give you a great return. The passive approach basically means:

- No risky endeavours
- Only invest in large companies
- A very well diversified portfolio
- No growth stocks

(Of course, these 4 points are interrelated)

A portfolio reflects who you are. To illustrate, a passive individual might put money into a savings account, whereas an active individual does whatever it takes to get the highest return. Being passive may result in a lower return, but it also gives a person less to worry about, whereas being active perhaps gives a higher return, but not without a lot of effort and stress. The passive approach is good for someone who is dependent on the investment for income, or someone who has little time to spend on stock picking. Also for beginners, it is a good idea to start out this way, while spending the first few years studying investments and testing one's own judgement.


Strategy

Diversify. Get both stocks and bonds. Consider dividing the portfolio 50/50 between bonds and stocks, and then adjusting the proportions depending on market developments, with an lower and upper limit of 25 and 75%. Reason to increase the common stock proportion would be whenever a prolonged bear market leads to bargain prices. In a prolonged bull market, the common stock proportion should be reduced, because prices go dangerously high. This is easier to say than to actually do. A good idea is to divide 50/50 between stocks and bonds, and when the market value of the stocks increases, sell as many stocks as necessary to bring proportions back to 50/50. If stocks drop, sell bonds and buy stocks to bring it back to 50/50.

Attitudes about stocks and bonds vary based on the market. In the late 1990s everyone thought they could become rich by buying only stocks (eg. Glassman & Hassett, Dow 36000: The new strategy for profiting from the coming rise in the stock market. Times Business 1999).



A common mistake is to get out of the stock market when prices drop, but you should not do that. You have to analyze stocks while not looking at the market price. In "bear-markets", periods in which investors are pessimistic about the economy and almost all stock prices drop, the good stocks go down in price as well, even if the company associated with it is doing just fine. When good stocks go down in price, you should buy more of them, not less, because a good company can survive a lesser period. When the market comes back up, you have a bunch of shares in your portfolio that increase in price, plus you have earned dividends all this time, and if you re-invested those, you have compound returns. One way to help you hold on through a falling market is to keep at least 25% in bonds (only high grade). More on bonds, treasury bills etc.

Diversification should also take place in within the stock portfolio. Strive to have at least 10 different ones (but less than 30, or you'll no longer be able to keep track of all of them). You don't have to handpick all of them. Index funds and mutual funds can be a good way to diversify because they contain many different stocks. If all your stocks go up and down in concert, you have not diversified properly.

You can find more about this in sources on "investment theory" and "portfolio theory":
http://viking.som.yale.edu/will/finman540/classnotes/notes.html
http://www.moneychimp.com/articles/risk/riskintro.htm

Market developments have to be viewed in perspective. For instance, if the price of the DJIA increases fivefold, while earnings and dividends increase only twofold, you know that the market increase is more due to investors' sentiments than actual company values.



Protection

In selecting investments, you take into account both what happened in the past, as well as your expectations about the future. Towards the future, you can take the predictive approach, or the protective approach. The predictive approach emphasizes that the safety of an investment is determined by qualitative factors such as prospects and management (as emphasized by super-investor Philip A. Fisher). The protective approach taken by Benjamin Graham emphasizes quantitative factors such as price, earnings, assets,dividends, etc. Protection is achieved primarily by (1) not paying too high a price, and by (2) diversification. The Margin Of Safety Principle, central to Graham's approach, states that the bigger the difference between the actual value of the company and the price you pay for the stock (a lower price), the more protected you are against unfavorable business developments, and your own errors of judgement.


Which stocks to select

1. Big companies (total market value > $2bil). However, nowadays, you can own small companies by buying a mutual fund specialized in small companies, or you can get an index fund.

2. Companies with low debt (get an idea of what is normal by comparing to other companies).

3. Uninterrupted dividend payments for at least 20 years.

4. No need for exorbitant earnings, but some earnings in each of the past 10 years, and an average annual earnings increase of at least 3 % per year, measured over 10 years.

5. Moderate P/E ratio, compared to others in the industry. http://biz.yahoo.com/p/industries.html


Other points

- Read annual reports. Once a company goes public, it is required by law to file all annual reports and other things with the Securities and Exchange commision (SEC). The SEC keeps all of that in a searchable database called EDGAR, accessible to everyone (www.sec.gov).

- Dollar-cost averaging is a good idea. This means investing a fixed dollar amount on a monthly or quarterly basis, so you automatically buy more shares when the price is low, and less when it is high.

To illustrate the advantage of dollar-cost averaging, suppose you had invested $12000 at once (i.e. without dollar-cost averaging) in the S&P500 in 1929, your investment would have decreased in value, to $7000 (1929-1939 captures a big market crash), whereas if you had invested $100 monthly, you would have $15000.

- Use your 401(k) plan. It is tax-deferred, and with a 401(k) plan, you can put your portfolio on autopilot. Rebalance once or twice a year, based on your life circumstances (as opposed to based on the market).


Warren Buffett:

According to Buffett, return on equity is more informative than earnings per share (p 95. "The essential Buffett", Robert Hagstrom, 2001). Buffett also uses owner earnings (net income plus amortization and depreciation, minus normal capital expenditures), rather than earnings or cash flow.

Buffett also says that once you've picked and bought the stocks, you should not drop your critical stance. Instead, you should re-evaluate your portfolio once a year, using the same criteria you used to pick the stocks in the first place. It is tempting to only follow market price once you have bought the stock, whereas you picked the stock by looking at business fundamentals. You should keep looking at those fundamentals. One advantage of buying smaller amounts at several times during the year, as opposed to one large purchase, is that you will automatically keep paying attention to the fundamentals.


Results you can expect

A defensive investor who does things right should expect a 3.5-4.5 % dividend return on stocks and gain some with an increase in value over time, thus gain about 7.5 % a year on stocks before tax, 5.3 % after tax ("The intelligent investor", Benjamin Graham, 1973.


Getting advice

When getting advice from a broker, explain what policy you want to follow. The broker, in turn, should help you execute that strategy.