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Building a passive portfolio

Lesson in Course: Portfolio management (beginner, 8min )

As a new investor starting out, what is a simple and effective strategy I can implement right away?

Building a simple portfolio is easy to do now with the different financial vehicles available. A passive portfolio doesn’t require as much attention and maintenance as an active portfolio and is generally a great place for beginners. 

Passive growth capturing strategies

In times of strong economic expansion and the continual rise in the stock markets, a growth strategy takes an aggressive approach to capture the gains. Here are examples of a few easy-to-implement growth portfolios. 

Most aggressive strategies

A pure stock portfolio provides very little protection against losses, but the tradeoff captures the most amount of gains when the markets are rising. 

While all stocks can be very risky, we can build some basic protection into this portfolio through diversification. ETFs or Mutual Funds are great vehicles to choose from since they have diversification already built in.

Mutual funds

Any growth mutual fund will include a basket of stocks in the technology and financial companies that generally see the highest growth. A value mutual fund will have a basket of more protective stocks such as consumer stocks and healthcare. While each fund already provides built-in diversification, picking a combination of different style funds helps add another layer of diversification.

Examples of setups:

  1. 100% of cash into a Growth fund
  2. 100% of cash into a Value fund
  3. 50% of cash into a Growth fund and 50% of cash into a Value fund (extra diversification)
ETFs

ETFs have lower expenses than mutual funds, but they are built around indices. Indices are stock-based or bond-based and are not reflective of portfolio strategies. The advantage of indices is also that machines completely manage the make-up and, as a result, lack the judgment errors humans tend to make.

Examples of setups:

  1. 100% of cash in the S&P500 ETF
  2. 100% of cash in the Russell 2000 ETF (riskier than the S&P500)

It’s not good to take too much risk if we need the money in the short to medium term.

Moderately aggressive strategies

In addition to diversification, mixing some bonds into the portfolio can add a lot more downside protection. 

In times of economic uncertainty, investors turn to bonds as a safe haven, and as stock prices drop, bond prices often go up. The inverse price movement of bonds helps offset losses from stocks. 

Mutual funds

Mutual funds' benefit over ETFs is that some of these strategies are managed and implemented by a professional fund manager. So instead of needing to find a stock mutual fund and a bond mutual fund and buying the right proportions to fit the strategies, there are plenty of mixed funds out there, and an investor can buy one fund and call it done. 

Examples of setups:

  1. 90% stocks and 10% bonds fund
  2. 80% stocks and 20% bonds fund
  3. 70% stocks and 30% bonds fund
ETFs

To use ETFs, we could use the same S&P500 ETFs or Russell 2000 ETFs; however, we would need to find a new bond ETF. For good downside protection, we can choose US Treasury ETFs with a maturity date of 10 years. Any treasuries with longer maturity dates have increased interest-rate risk.

Examples of setups:

  1. 90% of cash into an S&P500 ETF, and 10% cash into a 10-year treasury bond ETF
  2. 80% of cash into an S&P500 ETF, and  20% cash into a 10-year treasury bond ETF
  3. 70% of cash into a Russell 2000 ETF, and 30% cash into a 10-year treasury bond ETF
 

Protection strategies 

More conservative strategies are prudent when the future is less certain. 

These strategies are also great for people with shorter-term goals, such as saving for a downpayment on a house where they can’t afford to risk as much. While these strategies won’t earn as much as the aggressive strategies, they protect a lot more of the principal. If the market drops sharply, they also don’t require significant recovery periods to deal with losses. 

Mutual funds

For managed funds like mutual funds, adding more defense could include adding more protective instruments such as bonds and value stocks. The mutual fund managers will offer preconstructed portfolios that sometimes target a certain return. The managers try to achieve these returns through more bonds and predictable streams of income and growth.

Examples of setups:

  1. 50% bonds (often treasury) and 50% stocks mutual funds
  2. Absolute return mutual funds
  3. Protective funds
ETFs

The ETF strategy here is similar to the strategy above, just with more allocation into a bond ETF. Since the protection portion is a much larger portion of our portfolio, we could also consider some higher-yield bonds, such as corporate bonds.

Example of setups:

  1. 50% of cash into S&P500 ETF, 35% cash into a 10-year treasury bond ETF, and 15% cash into a 10-year corporate bond ETF.
  2. 30% of cash into S&P500 ETF, 20% of cash into a dividend ETF, 25% cash into 10-year Treasury bond ETF, and 25% of cash into a corporate bond ETF.

Different strategies work well for different investors, and there is no right or wrong strategy. For those just starting, choosing a more conservative strategy allows us to get a good feeling of things before making changes. 

Generally, the younger the investor, the more risk can be taken because there are more years to make up for potential losses. 

In the case of Paper Chase, a conservative strategy could be very effective for Grandma's Challenge.

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