[Editor: Today's guest post is written by one of our personally vetted financial advisors, Steven Podnos MD, CFP® of Wealthcare, LLC. You can read more about his background and philosophy in our interview.
One thing I really enjoy is hearing other people's takes on investing strategies and philosophies. It really makes me consider what my approach to long-term wealth and stability should and will be. Take a read and let me know what you think!]
One of the most powerful forms of passive income is the process of long-term investing in public markets. Yes, I mean stocks and bonds-global and highly liquid investments that take a minimal amount of your time, yet can build tremendous wealth over time.
Over time periods of a decade or more, stock investments earn several percentage points over taxes and inflation with great historic reliability. Fixed income usually earns less, but also has less volatility. And compared to real estate, when your stock and bond investments have downward volatility-you don’t get a property tax or insurance or repair bill like you do with real estate investments.
Investments in these assets can be termed “passive” or “active” depending on the particular investment vehicle you choose. Obviously, if you are picking individual stocks, you are performing an active process.
If you choose to invest in a mutual fund or an exchange traded fund (ETF), then you can choose between a computer buying an index (passive fund) or one that uses managers who are trying to beat the index they invest in (active management). The evidence is pretty good that passive funds (which are also less expensive) are the way to go for most investors.
However, just because the fund is passive, the process of investing remains active. If we examine the market capitalization of US stocks and bonds as well as non US stocks and bonds, we find that these four asset classes each contain about one quarter of the world’s investable securities.
A truly “passive” investing style would just own twenty five percent of each of these four asset classes. But no one does that. You or your advisor instead will pick some tilt toward more US stocks and bonds in most cases, as well as dividing up a portfolio into smaller asset classes.
Once this is done, you or your advisor will continue to actively manage the portfolio. From time to time, certain asset classes appear historically inexpensive based on valuation, dividend yields and other factors (think US stocks in 2010). Conversely, there are times when asset classes appear overly expensive by the same criteria (think of the tech stocks of 1999, real estate investment trusts in 2005).
The smart investor reacts to these facts by changing the asset allocation in a portfolio – true active management. Additionally, the starting asset allocation of a portfolio will drift over time as some of its components will increase in value more than others (and vice versa). The portfolio manager must decide whether or not the portfolio should be “rebalanced.” Not only should it be, but also how often, and by what criteria.
Having said above that passive type funds are usually the best way to invest, I’d suggest that there are exceptions to this policy.
Investing in markets that are not “efficient” (information about the securities in that industry or geographic region may not be widespread and accurate) may push me to invest at least some funds in active managers with either some expertise in the area or a physical location there.
Think of small companies in Southeast Asia-perhaps an investment firm located in Hong Kong might have an “edge” over a blind index. Also, consider active management in complex investments. For example, we use many active fixed income managers who are able to invest across a broad type of securities on a global basis. There really is no comparable “index.”
So, investing in global stocks and bonds is a great way to make passive income. But it is an active process that requires some education, discipline, and patience.
Steven Podnos MD CFP® is a fee-only financial planner in Central Florida. He practiced Pulmonary/Critical Care Medicine for over two decades and continues to serve in the USAF Reserve as a Flight Surgeon. He can be reached at Steven@wealthcarellc.com or at www.WealthCareLLC.com.