Investing is a means to put money away for the future and have that money work for you so that you can reap the full benefits of your labor in the future. Assume you have $10,000 saved up and are ready to go into the investment world. Or perhaps you merely have an extra $50 each week and want to start investing.
In this post, we'll guide you through the steps of becoming an investor and teach you how to optimize your profits while reducing your expenses.
It is extremely difficult for a beginner investors to do stock picks, especially when they are not able to decipher the mystics behind the financial reports. Or even if they can, it requires a lot of effort and often the market behaves irrationally.
This is why we will focus this time on the passive ways to invest, as present several advantages, together with the fact that they require significantly less time to spend from an investor, thus it is very suitable for beginners and hobbyists.
Passive Investing
Passive investing methods attempt to avoid the fees and underperformance that can result from active trading. The goal of passive investing is to gradually accumulate wealth through a buy-and-hold strategy, unlike active traders,
Passive investors do not seek to profit from short-term price fluctuations or market timing. The underlying assumption of passive investing is that the market will produce normalized positive returns over time.
By holding all of the securities in the target benchmarks, index funds spread risk widely. Rather than seeking winners, Index Funds tracks a target benchmark or index, avoiding the need to constantly buy and sell securities. As a result, their fees and operating expenses are lower than those of actively managed funds.
Passive investment involves fewer purchases and sales versus active investing, which can result in lower expense ratios. Passive Funds only have transaction expenses of between 0.1-0.2%, which is much lower compared to Active funds, where managers charge an expense ratio of as much as 2%.
Passive Investing also requires lower maintenance, as the strategy relies on achieving long-term returns. A passive investment strategy also poses a much lower risk to investors compared to an active investing strategy, as it relies on investing in a broad mix of assets compared to investing directly in an individual stock.
That can be very well combined with the well know Dollar Cost Averaging technique which is telling to add additional funds during a defined period, for example monthly.
Index Investing
Index investing is a passive investment strategy that seeks to replicate the returns of a benchmark index. Making investments hands-off eradicates most of the other unconscious biases and uncertainties that arise in a stock-picking strategy.
In 2021, of the 3,000 active funds that deployed an active strategy, only 47% outperformed their passive counterparts. Over the long term, the statistic is even worse, with nearly 85% of active Monet managers underperforming the S&P500.
See below the return of S&P500 since 2010. That's quite impressive considering you had to do nothing, just buy and hold and get a 4x return.
Of course, not all the decades are so successful, but in case of recessions investors barely do better either.
Passive Dividend Investing
Dividend stocks are among the most straightforward ways for investors to generate passive income. As companies generate profits, a part of the bottom line is diverted off and distributed to shareholders in the form of dividends.
Dividend yield greatly varies across industries, and can also fluctuate based on the financial performance of a company. In general, three key factors determine the total income an investor can receive from Dividends, including Dividend Yield, Growth Rate and Payout Ratio.
The dividend yield is the percentage of dividends received per share concerning the current price of the stock. For instance, let’s take the example of a Dividend Aristocrat to understand yield (a dividend aristocrat stock is one that consistently raises dividends for 25 years).
Telecom stock AT&T is currently trading at $23.78 per share, with an expected forward annual dividend rate of $2.08. This implies a dividend yield of 8.69%.
Dividend Growth is an important factor that determines the expected future passive income. AT&T’s dividends have grown by 24% in the last 10 years. The dividend payout ratio is the proportion of dividends relative to the earnings of a company. A company with a higher payout is retaining a limited amount of cash with itself, implying that the business has matured.
In the example of AT&T, the dividend payout stood at 75.36%, implying that the company retains 24.64% of its current earnings.
The big catch is about re-investing the dividends. That means you get more shares, and so, more dividends in the future. Let's see an example
Below is a picture of a $10,000 portfolio growth since 2010, which is 100% consisting of AT&T stock.
The first graph is without re-investing the dividends. As you can see, the stock is drifting and the total return over the decade is indeed negative.
On the second chart, we see the portfolio growth while all the dividends are re-invested. And this time, the portfolio value is sitting at about $18,000. Impressive how much difference on the same stock.
I hope I was able to convince you that dividends can play a significant role in a portfolio.
You can find more info about dividend investing in our dedicated category Dividend Stars.
Using these metrics, investors can identify a basket of securities that generate dividends that meet their passive income criteria. In general, dividend-paying stocks generate 3% annual returns. A customer with $10,000 invested in their dividend portfolio would thus be able to generate $25/month in passive income.
Strategic Asset Allocation and Modern Portfolio Theory
Strategic asset allocation is an investing strategy that employs insight to determine what proportion of one's assets ought to be in stocks, bonds, cryptocurrencies, and cash—as well as how to divide one's investments among these asset classes.
This method of portfolio allocation aligns the makeup of the portfolio after accounting for an investor's tolerance for risk. Strategic Asset Allocation is based on the Modern Portfolio Theory (MPT). MPT, which was constructed by Henry Markowitz in 1952, states that, if given a choice, investors would opt to reach their financial goals by opting for the least amount of risk.
Since its introduction, MPT has become a key strategy used by asset managers, in conjunction with a buy-and-hold strategy.
Strategic asset allocation relies on an individual investors tolerance for risk, to the desired returns expected from their portfolio. An investor who is pursuing an aggressive strategy will look for an asset mix of 60% stocks/ 30% cryptocurrencies/ 10% cash, while an investor looking to retire soon will employ a cautious approach by using an asset allocation approach of 40% stocks/ 40% bonds/ 20% cash.
Based on the returns of an individual asset class, an investor dynamically adjusts their portfolio to limit the risk.
Let’s take the example of the cautious investor, who employs a 40/40/20 asset allocation mix for Equities/Bonds and Cash in his $500,000 portfolio. This implies that he allocates $200,000 to Equities & Bonds, and $100,000 to Cash. Assuming that Equities grows at 12%, Bonds at 4% and Cash at 1% over the next year, the weighted average return of the portfolio is expected to be 6.6%.
As a result, the portfolio is expected to grow to $533,000 by the end of the year, with Equities being at $224,000, Bonds at $208,000 and Cash at $101,000. So, the new weights are as follows: Equities at 42.02%, Bonds at 39.02%, and Cash at 18.94%. As a result, the investor needs to sell $10,800 worth of equities, which is then re-allocated to Bonds (add $5,200) and Cash (add $5,600), to generate the expected return at the same level of risk moving forward.
You might be wondering why stocks are diversified with bonds. The thing is about correlation. In order to truly diversify, the investor shall hold assets which are poorly correlated, meaning when the one goes down the other might go up and compensate the loss.
Conclusion
I hope this will be useful in your investment journey. Please note that nothing in this article shall be considered as an investment advice. Make you own research before putting your capital at risk.
Even if passive investing is not a juicy strategy, it might help you to put your money to work while you dedicate time to study and enhance your financial literacy. For that we can advise to follow our website and blog:
