Passive Investing: Embracing the 80/20 Rule

As the thrill of quick gains often grabs headlines, passive investing emerges as the silent giant, embodying the virtue of patience in a race paced by speculation. It’s the strategy that champions the adage “slow and steady wins the race,” turning a deaf ear to the siren calls of market timing and rapid trading. Surprisingly, passive investing often beats the index too!

This blog post delves into passive investing—a philosophy encompassing investor mindset and portfolio tactics. It advocates a steadfast ‘buy-and-hold’ strategy, low transaction costs from minimal turnover, and prioritizes long-term diversification.

While often conflated with index investing, a popular subset, passive investing encompasses a broader spectrum. It allows investors to step away from the financial noise, avoid the pitfalls of emotional trading, and, instead, benefit from the underlying growth trajectory of the markets.

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What is Passive Investing?

Passive Investing is a broad investment strategy aimed at achieving long-term returns by minimizing buying and selling actions. It is called “passive” because the investor accepts market prices as they are and doesn’t attempt to beat the market by “trading”. Instead, passive investors build portfolios and hold them with the expectation that, over time, they will match or beat both index portfolios and active investors.

Characteristics of Passive Investing:

• Buy and Hold: Passive investors typically buy securities and hold them over a long period, regardless of market fluctuations.
• Low Fees: Because there’s minimal trading, passive investing often incurs lower fees than active investing.
• Diversification: Passive portfolios often hold a range of investments to spread risk. But some passive portfolios are concentrated.
• Avoid Psychology: Most passive investing approaches avoid the pitfalls of investor bias because they don’t rely on market timing.

Index Investing

Index Investing is a subset of passive investing. It refers to the practice of investing in a portfolio of assets that replicates the composition of a market index. An index is a selection of securities that represent a segment of the market, like the S&P 500 for large-cap U.S. equities, or the NASDAQ for technology-based stocks.

Characteristics of Index Investing:

• Market Representation: Index funds aim to mirror the performance of a specific index.
• Automatic Rebalancing: As the underlying index changes its composition, the index fund automatically adjusts its holdings to match.
• Cost Efficiency: Index funds often have lower expense ratios than actively managed funds because they don’t require a team of analysts and extensive research to manage.
• Performance Tracking: The success of an index fund is measured by how closely it tracks the performance of its benchmark index.

While all index investing is passive, not all passive investing strictly follows an index. For example, a passive investor may construct a custom portfolio that isn’t aligned with an index but still adopts a buy-and-hold, low-turnover strategy.

Buy-And-Hold: Passive Investing

Buy-and-hold strategies select investments for long-term holdings, ignoring short-term market fluctuations. This approach trusts in market returns over time, minimizing costs and taxes by avoiding frequent trading.

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Now, let’s look at how buy-and-hold strategies can be applied in different investment areas such as the stock market, real estate, and a family business, through hypothetical case studies.

1. Stock Market Investing: Jane’s Long-term Equity Portfolio

Jane is an investor who believes in the long-term growth potential of the stock market. She creates a diversified portfolio of blue-chip stocks, which are known for their stability and consistent dividend payments. She also adds a mix of growth stocks from different sectors, like technology and healthcare, to balance her portfolio for potential capital appreciation.

• Passive Strategy: Jane does not react to short-term market dips or spikes. She believes that the companies she has invested in have solid fundamentals and will perform well over the long term.
• Results Over Time: Over a period of 20 years, Jane’s portfolio experiences several market cycles, including downturns and recoveries. However, due to her buy-and-hold approach, she benefits from compounding dividends and long-term capital growth, outperforming many active traders who attempted to time the market.

2. Real Estate Investing: Ahmed’s Rental Properties

Ahmed invests in a residential property that is in a growing neighborhood with good schools and amenities. He believes that the area will continue to attract families and working professionals, leading to an appreciation in property values and steady rental demand.

• Passive Strategy: Instead of flipping houses or developing real estate, Ahmed takes a buy-and-hold approach, renting out his properties to tenants. He maintains the properties to preserve their value and ensure tenant satisfaction.
• Results Over Time: The neighborhood does indeed grow in popularity, and Ahmed’s property values increase. By not flipping his properties, Ahmed has reduced the transaction costs associated with real estate investing. And by holding his properties for the long-term, Ahmed has remained focused on maintaining them strategically which has contributed to their increased value.

3. Family Business: Liu’s Family-Owned Restaurant

The Liu family owns a restaurant that serves local cuisine. Instead of constantly revamping the menu or following short-lived dining trends, they focus on maintaining high-quality standards and traditional recipes that have been passed down through generations.

• Passive Strategy: The Lius believe in the timeless appeal of their dishes and invest in their community relationships rather than expanding rapidly or rebranding. They train the next generation of the family to run the business, ensuring continuity.
• Results Over Time: The restaurant builds a strong reputation for quality and tradition. While other trendy restaurants come and go, the Liu’s establishment becomes a landmark in the community, attracting a loyal customer base that sustains the business for years.

Passive Investing: Philosophically Superior?

Each case study shows a passive, buy-and-hold strategy emphasizing long-term views and enduring investment value.This approach can provide stability and potential growth through compounding effects over time.

Passive investing strategies often outperform indexing strategies under many conditions, especially when considering the nuances of index construction and maintenance as well as tax strategies like those related to charitable donations. Here’s a closer look at these aspects:

Nuances of Index Construction and Maintenance

1. Market Capitalization Weighting: Indexes weigh by market cap, favoring larger firms. This may concentrate risk and overvalue top companies.
2. Rebalancing and Reconstitution: Indexes periodically rebalance and reconstitute their holdings to reflect changes in the market. This can force index funds to buy high (adding stocks that have increased in price) and sell low (removing stocks that have decreased in price), which is the opposite of the ideal investment strategy.
3. Mechanical Nature: Index funds are programmed to follow set rules without deviation, which can sometimes result in suboptimal decisions, such as the automatic inclusion of overvalued stocks or exclusion of undervalued ones.

Detriments of the Mechanical Nature of Index Investing

• Lack of Flexibility: Index funds must adhere to the rules of the index, which means they cannot take advantage of certain market conditions or make judgement calls based on changing information.
• Price Insensitivity: Since index funds are required to buy and sell holdings based on index adjustments, they do not have the luxury of waiting for a more favorable price.
• Impact on Performance: The costs associated with frequent rebalancing can impact performance, as can the forced selling of assets to meet redemption demands in a down market.

Benefits of Holding a Passive Portfolio of Individual Stocks

1. Control Over Constituents: When holding individual stocks, investors can decide exactly which companies to include in their portfolio, potentially avoiding overvalued stocks or sectors.
2. Tax Efficiency: Managing a portfolio of individual stocks allows for more control over capital gains realization. Investors can decide when to sell and can use strategies like tax-loss harvesting to offset gains.
3. Strategic Donations: For Canadian investors, donating appreciated securities directly to a charity can be particularly advantageous. The capital gains on the donated securities are not subject to tax, which means the investor can make a larger donation and receive a tax receipt for the full market value of the donation, leading to a larger tax benefit.
4. Case Example: Suppose a Canadian investor has a portfolio of various stocks that have appreciated in value. They decide to donate a portion of their holdings to a charitable organization. By donating the securities directly, they avoid paying capital gains tax on the appreciation. This not only provides a tax benefit to the investor but also allows the charity to receive a larger gift. Using an index fund limits control and tax optimization. Donating high-gain securities maximizes tax benefits and rebalances the portfolio.

Pareto Principle and Passive Portfolios

The Pareto Principle, known as the 80/20 rule, suggests that 80% of outcomes come from 20% of causes. In a passive investment portfolio held over many years, it’s common to see significant gains from a small number of holdings. This happens because, in a diverse portfolio, certain investments will outperform others, often by a substantial margin. For an example of this, consider the Coffee Can Portfolio.

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Additional Passive Investing Observations:

Performance Disparity: Over time, some companies will naturally outperform others due to stronger business models, better management, or being in a faster-growing industry. These companies will grow to represent a larger portion of the portfolio.

Concentration Risk: As high-performing stocks become a larger part of the portfolio, the portfolio becomes more sensitive to the performance of these few holdings. This increases concentration risk, where the portfolio’s fate becomes tied to the performance of a small number of stocks.

Sector Dominance: In some cases, entire sectors might outperform, leading to a sector concentration within a portfolio, which can create additional risks if that sector experiences a downturn.

Passive Investing in Practice

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