Passive Investing: A How-To Guide

The two investment ideas presented here are what’s called passive, buy-and-hold investing. You pick your investments, you invest your money, you let it sit there for the long haul.

With buy-and-hold investing, generally the only tinkering you need to do with your investments after you create your portfolio is to rebalance, which means moving money between your investments to make sure the percentages invested in stocks and bonds continue to match your desired asset allocation. (Read about what asset allocation is and why it matters.)

Target-date funds were created to be a one-stop-shop investing product for people saving for retirement. Many workplace retirement plans such as 401(k)s offer access to these set-it-and-forget-it funds.

If you don’t have a retirement plan at work, you can open a traditional or Roth IRA at a broker and invest in a target-date fund yourself. (Find the best brokers for IRAs).

A target-date fund (also called a lifecycle fund) is a mutual fund that invests in other mutual funds to provide a highly diversified investment portfolio that is managed for you over the course of your working life and even into retirement. (A mutual fund is a type of investment where investors pool their money to buy shares of stocks or bonds; some mutual funds invest in hundreds or even thousands of companies.)

Finding the right target-date fund for you is as simple as picking the one that’s titled with the year you plan to retire (see some examples below). And it’s fine if you don’t know when you’re going to retire; simply pick the target-date fund with the year closest to, say, your mid-60s.

Some target-date fund caveats

As with any investment, there are some details to consider when investing in target-date funds.

Target-date fund caveat: An added fee

Most mutual funds charge fees called expense ratios (essentially a management fee). With a target-date fund, generally the fund is investing in other mutual funds, and usually you’ll pay the expense ratios of those underlying mutual funds plus an expense ratio for the manager of the target-date fund.

In other words, a target-date fund typically carries higher fees compared to building your own investment portfolio. However, the convenience of professional management, along with the benefit of having an expert actively monitoring and adjusting the fund, can save you significant time.

If you’re investing through a workplace plan like a 401(k), you’ll simply have access to whatever target-date funds are offered by the plan and you won’t be able to shop around on fees. (It still can be a good idea to invest in your workplace plan. Here are tips on finding the best retirement plan for you.) But if you’re going to invest in a target-date fund through your own IRA, then shop around.

Target-date fund caveat: ‘To’ retirement vs. ‘through’ retirement

Some target-date funds invest to your retirement date — that is, they assume you’ll withdraw your money and stop investing around that date. But many target-date funds invest based on the assumption that you’ll stay with the fund through your retirement.

While the portfolio shifts to more conservative investments as your retirement date approaches, the fund may still be quite heavily invested in stocks because the fund manager expects you to keep your money in the fund during a retirement that could last 20 to 30 years.

This question may not matter much in your 20s, but once you’re getting closer to retirement, it makes sense to look closely at your target-date fund to see what the plan is for your invested money, and make sure it aligns with your goals.

Target-date fund caveat: More time to retirement = more aggressive investments

If the thought of having your money 90% in stocks kinda freaks you out, then consider choosing a target-date fund with a shorter timeframe. The closer the target-date fund is to the retirement date, the more conservative it’s likely to be. Conversely, if you’re a fan of maximizing potential returns, then pick the furthest-out date you can — that’s likely to be the fund most heavily invested in stocks.

Lazy Portfolios are another simple, set-it-and-almost-forget-it way to invest for retirement. Each Lazy Portfolio is made up of a handful of index mutual funds or ETFs and you simply invest in exactly those same funds, or find very similar funds (for example, a total stock market index mutual fund). Then sit back and relax, more or less, until retirement.

The benefits of Lazy Portfolios

These investment portfolios will be cheaper, generally, than a target-date fund, and you control what you’re investing in. But a lazy portfolio, even though it’s nice and lazy, does require a little more of your hands-on work than a target-date fund.

First, you have to find the investments that match the portfolio (very easy through a brokerage account; more challenging if you’re investing in your workplace retirement plan, which will have fewer investment choices).

Secondly, you’re in charge of rebalancing when your asset allocation gets bumped around by market moves. On the plus side, a Lazy Portfolio is going to be one of the hands-down cheapest ways to invest for retirement.

Lazy Portfolio examples

Below are three well-known lazy portfolios. (To find out more about Lazy Portfolios, check out the Bogleheads, a community of buy-and-hold investors, named after John C. “Jack” Bogle, founder of Vanguard and creator of the index mutual fund.)

Note that some of these portfolios refer specifically to Vanguard index mutual funds or ETFs, but these days there are so many index mutual funds and ETFs, you can easily create these same portfolios with mutual funds or ETFs from other companies.

For example, Fidelity, Charles Schwab and Vanguard all offer an index fund that tracks the S&P 500 index — all of these funds have “500 index fund” in their name. Similarly, many fund companies offer a total bond fund.

Any fund’s summary description will include the fund’s objective and strategy, e.g., “to track the performance of the S&P 500 index,” so be sure to read that if you’re not sure. Google isn’t always your friend when researching mutual funds — search results don’t always include the fund’s description — so you might need to go directly to the fund company’s website to search for the fund. Always be sure to look for the lowest-cost funds you can find to maximize your long-term returns.

William Bernstein’s No-Brainer Portfolio

William Bernstein is a well-known money manager, and neurologist, who has written many books on investing. His Lazy Portfolio involves simply dividing your money evenly among these four index mutual funds:

• Vanguard 500 Index (VFINX)
• Vanguard Small-Cap Index (NAESX)
• Vanguard Total International Stock Index (VGTSX)
• Vanguard Total Bond Market Index (VBMFX)

Rick Ferri’s Two-Fund Portfolio

Rick Ferri, a money manager and author of many investing books, offers the simplest of lazy portfolios: You invest in one global stock market fund and one broadly diversified, investment-grade bond fund, such as Vanguard’s Total World Stock ETF (VT) and Total Bond Market ETF (BND).

Ferri doesn’t designate how much money you put in the stock fund vs. the bond fund, so you get to choose. You could go with an 80/20 portfolio (80% stocks and 20% bonds), a 60/40 one, a 20/80 one, or anything in between. It comes down to your tolerance for risk. Read our story on asset allocation for more info on how to make this decision.

Scott Burns’ Margaritaville Portfolio

Scott Burns is a longtime financial writer. His Margaritaville portfolio is equal parts of a total U.S. stock market fund, a total international stock market fund and a total U.S. bond fund. He also created the Couch Potato portfolio, which is equal parts a total U.S. stock fund and a total U.S. bond fund.

Some Lazy Portfolio caveats

As with option No. 1 (aka target-date funds), there are some factors to consider.

Lazy Portfolio caveat: You have to pick a Lazy Portfolio

There are a lot of Lazy Portfolios to choose from and for some people that can lead to decision paralysis. The most important thing is to simply get started investing for retirement. Just pick a portfolio and go with it, and if you have second thoughts, then consider hiring a financial advisor, or shift your retirement savings over to a target-date fund.

For many of us, now that old-school pensions are pretty much a thing of the past, saving for retirement is on our shoulders, and the potential gains offered by the stock market could be the difference between a fun retirement and financial struggles. Frankly, my take is that Social Security absolutely will be there for anyone currently in the workforce, but benefits may decrease and, even today, benefits aren’t enough to fund a super relaxing retirement.

Lazy Portfolio caveat: You have to find mutual funds that match a Lazy Portfolio

If you’re investing through an IRA or Roth IRA at a big-name brokerage such as Charles Schwab, Fidelity or Vanguard, you’ll have no problem finding the exact mutual funds and ETFs that match a Lazy Portfolio’s holdings. Here’s a roundup of the best brokers for IRAs.

That’s not so true if you’re investing through your retirement account at work. You absolutely want to get any matching funds your employer offers — that’s free money, after all! — but if the investment options aren’t great, then look for a target-date fund or the cheapest mutual fund you can find in your plan, contribute enough each paycheck to get your company match, and then also open a traditional or Roth IRA at a brokerage so you can build your own Lazy Portfolio there.

If you do end up with multiple retirement accounts, be sure to think of them holistically. Combined, those accounts comprise your investment portfolio and you want to make sure you’re as diversified as possible.

Lazy Portfolio caveat: You’ll have to do the rebalancing

With a target-date fund, the fund manager makes sure that the target-date fund stays within its preset asset allocation. Not so if you take the Lazy Portfolio path. You’ll need to check in with your investment account at least once a year or so to make sure your 70/30 portfolio (70% stocks and 30% bonds) hasn’t turned into, say, an 83/17 portfolio.

The good news is: A shift like that means your stock holdings have gained in value. But it also means you’ll want to shift your portfolio so it gets back to your 70/30 allocation. You can do that by selling some equity holdings and increasing your bond holdings, or you can do it by directing more of any new money you put into the account into bonds.

Target-date fund

Pros:

• Super simple and easy one-stop shop
• Professional management includes rebalancing and shifting to more conservative allocation as retirement date approaches

Cons:

• Even the cheapest target-date fund is likely to have an added fee to pay for the management of the fund, and thus will be more expensive than a Lazy Portfolio or a portfolio you put together yourself
• Buy-and-hold means watching account value rise and fall over time

Lazy portfolio

Pros:

• Ultra low cost
• Easy to set up

Cons:

• Many Lazy Portfolios to choose from can make it hard to pick
• May be impossible to find “matching” investments in your workplace retirement plan
• Buy-and-hold means watching account value rise and fall over time