FINANCIAL FOCUS: Passive investing in today's market
CHARLESTON - One day my friend Gary Swingle invited me to lunch. At lunch, Gary gave me the book "The Only Guide to a Winning Investment Strategy You'll Ever Need" by Larry E. Swedroe.
In this book, the author explores the difference between "active" and "passive" investing, and tells how you can win the investment game through long–term passive investments in such indexes as the S&P 500, instead of through the active buying and selling of stocks.
The book has three sections:
* The first part of the book describes why short-term trading, or trying to time or beat the market by following investment pundits' advice, is a "loser's game."
* In the second part of the book, the author explains the efficient markets and modern portfolio theories.
* The third part of the book is the most interesting because this is where Swedroe illustrates the benefits of modern portfolio theory by showing long-term risk returns.
Swedroe lays out a rational, systematic approach toward building a diversified portfolio, based on the investor's liquidity constraints and management of assets in taxable and non-taxable accounts. He demonstrates how to earn higher rates of return through the application of passive investing, asset allocation and regular rebalancing of your portfolio.
Passive Strategy: According to Swedroe, there are three basic types of investment vehicles available to implement a passive strategy:
1. Index funds
2. Passive asset-class funds
3. Exchange–traded funds (ETFs)
Index Funds: An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the S&P 500 or the Russell 2000. An index fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.
Passive Asset-Class Funds: An asset class is a group of securities that have similar risk characteristics. Passive asset-class funds, while investing only in securities within a specific asset class, have the advantage of not trying to replicate an index. Instead, they focus on achieving the greatest returns for a given level of risk.
Exchange-Traded Funds: Exchange-traded index securities, for all practical purposes, act like open-ended, no-load mutual funds. Like mutual funds, they can be created to represent virtually any index, asset class or sector. ETFs offer the potential for greater tax efficiency, lower annual operating expenses and more flexible trading characteristics.
The central concept of the book is to demonstrate how to use a passive approach to investing and consistently get market or above market rates of return. The author makes a very strong case for the use of index funds as the primary investment tool of an investor.
Swedroe compares the average performance of actively managed funds and shows statistically that, in most cases, it is not possible to beat the market consistently. You may able to beat the market in selected years, but over the long run the passive approach will generally win.
Nistendirk is a partner at Woomer, Nistendirk & Associates PLLC, a CPA firm located in Charleston. Bob has extensive experience in tax accounting, strategic planning and financial/business consulting. He can be contacted at email@example.com.