My Beginner’s Understanding of Investing – Part 7: Passive Investing

Ok, so let’s recap (so my Pattern Thinking brain can know exactly how it all fits together!) on what I have learnt so far:

So let’s discuss passive investing a bit more. Since my last post my brother has pointed me to this article, which states that it shouldn’t be passive investing OR active investing. But rather, passive investing AND active investing. This is because they actually complement each other. Basically, they perform best in completely separate areas of the equities market (check out the article, dear Reader, it’s got some great diagrams/pictures that make it easy to get the basic picture 🙂 ), which means that they can actually be friends:

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Frankly, I was relieved when I read this article. This is because it was bothering me that I couldn’t understand why the industry of actively managed funds exists if passively managed funds consistently do better in the long run. Also, I’m totally a fan of inclusivity and to be honest I was starting to feel sorry for the poor actively managed funds who nobody seemed to want…

Having said that though, I’m not running head-first into actively managed funds just yet. Definitely later but for now we are just starting our investing journey and so I want to begin with the easy, couch potato route i.e. invest in the well-established, large, general market (as opposed to niche areas) using passive investing.

So, what is passive investing?

Passive investing = buying index tracking funds. Great. So, what is a fund I hear you ask, dear Reader? A fund = A lump of money. In the case of passive investing that lump of money buys into a collective investment scheme that copies/tracks/follows a chosen index or market. There are no clever analyses or assessments. It simply tries to copy as closely as possible whatever it is trying to copy. Kind of like the shadow game that we used to play as kids 🙂

For example, the SATRIX 40 in South Africa tracks the top 40 companies in the JSE (South African stock market); and the S&P 500 in the USA tracks 500 companies in the USA stock market. Index tracking funds can track anything: an entire market or a specific industry or section of the market (for example, the housing market or the top 10 companies in a stock market etc). For more information check out Investopedia where it explains really nicely exactly how an index works.

So now that we know what passive investing is, the big question is: why is it so great?

  1. From my beginner’s understanding, one of the beauties of the fact that it tracks an index/market is that it is naturally diversified.
  2. If I buy something like the SATRIX 40 and one of the top 40 companies goes to pot, it’s not a problem. This is because the fund tracks the top 40 – it doesn’t actually care what those top 40 are specifically. (Number gurus please correct me if I’m wrong on this!!)
  3. The brilliance of having no fancy analyses and assessments is that the fees don’t have to pay fancy people to do the fancy analyses and assessments J In other words, the fees tend to be cheaper than actively managed funds (but not always!). The rule is that the higher the fee the harder it is for the fund to track the index/market and so the less likely it will be to do what it’s supposed to. The brilliance of low fees is that there are also less fees compoundly eating away at my returns 😀
  4. It doesn’t require much from me the investor. It is totally novice-friendly, lazy-friendly and number-panicker-friendly 🙂
  5. It aims to build slow, steady wealth over the long-term. Which suits my financial independence (laziness?!) aspirations very well 🙂

Just to provide the whole picture, let’s also talk about what isn’t great about passive investing:

  1. It takes time. This isn’t going to make me rich quick.
  2. I need to be intelligent about the one part of it that actually requires something of me: choosing which exact passive investing product(s) I want to go with.
  3. The cheapest funds are through Vanguard and I’m not American. (Once we’re living in New Zealand we could access Vanguard but with additional fees).

There are two types of passive investments:

passive-investing

 

 

Index Tracker Unit Trusts (Tracker Funds; Unit Trust Tracker Funds) Exchange Traded Funds (ETFs)
–       Work like unit trusts

–       Fee structure simpler

–       Only bought and sold at the end of the day

–       Traded like shares

–       Fee structure more complex

–       Can be bought and sold all day

 

 

Despite my efforts at trying to compare them, it isn’t very clear which are better though: Index Tracker Unit Trusts or ETFs… However, I’m starting to suspect that the distinction is not actually very important for an average investor like me (any Number Gurus have any thoughts on this?!)… But I did find this quote quite helpful:

 

“As the analysis is complex even for the most financially astute, it is not surprising that the debate is becoming heated.  When in doubt, stick to one rule: simplicity.  ETFs are best left to professional investors who need to access more specialist and esoteric strategies as a component of their portfolios, and who understand the benefits and the constraints.  For retail investors who want to access plain vanilla index-tracking there is no substitute for unit trusts”. – EFTs vs Unit Trackers

 

The reality is that I probably won’t worry myself too much about whether I buy Unit Trust Tracker Funds or ETFs when the time comes. This is because I imagine that I will be much more focused on the other things I’ve learnt…

 

Based on all my reading, my mantra for passive investing will be:

  • Lesson 1: choose one with low fees (an annual fee lower than 1% per year)
  • Lesson 2: research the fees EXTENSIVELY to make sure there are no hidden costs
  • Lesson 3: buy regularly (dollar cost averaging but also the beautiful wealth-growing habit of saving first)
  • Lesson 4: buy and forget about it – this means that I won’t follow the inevitable up and downs of the stock market. Instead I will keep selling to a minimum to avoid extra fees and to give my investment time for compound interest to work it’s magic 🙂

 

What are your thoughts, dear Reader? Do you think that I’m on the right track? I hope so because the next step is to integrate everything that I have learnt about investing so far into our actual, real-life situation now…

 

Xxx

 

P.S. If you’re wanting some extra reading on passive investing this was a great article that explains things very nicely (simply?!): How to find the cheapest and best index tracker funds and take the hassle and cost out of investing

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