Are you tired of the poor performance of your actively managed mutual fund? If so, a passive investing strategy is an alternative to paying a manager whose performance is beaten by the averages. Passive investing essentially means you are buying an index fund. It doesn't require a lot of time to set up, and it is usually the least expensive option.

Even the many mutual funds that mirror the performance of indexes involve risks. If the market goes down, your investments are guaranteed to suffer. How can you enjoy the low fees of passive investing while having sufficient diversification that provides an optimal risk/return trade-off? Let's take a look at the couch-potato portfolio.

The Couch-Potato Portfolio
This strategy was created by Scott Burns, a personal-finance writer for the Dallas Morning News. The original strategy involved investing half of an investor's assets in an S&P 500 Index fund and half in a fund mirroring the Shearson/Lehman Intermediate Bond Index. (Burns used the Vanguard 500 Index and the Vanguard Total Bond Fund Index.)

Those with higher risk tolerance can modify the 50/50 asset allocation strategy to 25% in the Vanguard Total Bond Fund Index and 75% in the Vanguard 500 Index. The 25/75 allocation is known as the "sophisticated couch-potato portfolio." The higher weighting in equities is more suitable for younger investors; those closer to retirement need more security. Ever since the concept originated, the couch-potato strategy has been modified to suit individual needs from various countries.

Strategies To Avoid Tax Penalties And Other Difficulties
Investors wishing to formulate a couch-potato portfolio within their 401(k) plans may run into some difficulties. Depending on the plan manager, some 401(k) plans do not offer Vanguard funds. Some plans have a self-directed brokerage account option, which allows investors to purchase the assets for a couch potato portfolio, but the fees can make this option expensive and not worthwhile. The 50/50 asset allocation strategy, however, may be applied to your portfolio without the penalties of additional brokerage costs. From the funds offered in your 401(k) plan, invest 50% in an equity index fund and 50% in a Treasury index fund or short- to medium-term government bond fund.

Additionally, if the couch potato portfolio isn't possible in your retirement plan, an alternative strategy is to invest half of your portfolio in a tax-free Treasury fund rather than a Treasury index fund.

After you have set your asset-allocation strategy, your portfolio will require a yearly rebalancing in order to maintain the 50/50 or 25/75 allocation.

How Well Does It Perform?
In Burns' 2002 update, his couch potato portfolio obtained a 10.37% total return from 1991 to 2001. The average balanced fund returned 9.45%. In addition, during 2001, the average domestic equity fund lost 11.32% while the couch potato lost only 1.80%. Even with the additional risk undertaken by investors using the sophisticated couch-potato portfolio strategy, the portfolio lost 6.91% during the same period. Over the period of 1986 to 2001, the sophisticated couch potato strategy returned 12.3% while the average equity index returned 11.85%. In the periods measured, both the regular and the sophisticated strategies are able to offer a respectable return while protecting the investors from significant losses.

Why Does Laziness Pay Off?

The key is diversification. Diversifying your portfolio with both fixed-income and equity securities allows an investor to limit losses during periods of bearish equity performance.

Consider, for instance, the stock market decline from 2000 to late 2002. If an investor had chosen to allocate his or her assets 50/50, the portion of the investment in the bond markets would have remained stable or performed well during the period of unrest within the equity markets.

Second, funds that mimic indexes will almost always have lower fees because of the passive investment strategy of managers of index funds. Fewer transactions translate into fewer expenses for the investor.

Finally, the return investors gain is not a result of taking big risks. For the most part, this strategy offers sound gains while allowing investors to sleep soundly each night.

How To Do It Yourself

Are you better off with the 75/25 strategy or should you stick to 50/50? The main issue here is the length of time that you have to work with. Investors wanting to expose themselves to more equity should have a longer investment horizon. Predicting the return on the stock market over a few years is difficult if not impossible, but predicting it over the long term is easier. Using history as our guide, we can be fairly confident that we will receive satisfactory returns when we invest for 10 years or more. Those investors who don't have at least 10 years to work with should consider taking a more conservative stance.

In addition, if an individual has any special tax considerations, the couch-potato portfolio will not be as easy to create and may not be the most appropriate. Check with your tax professional for the best choice for you.

Other than that, begin choosing your funds! Most mutual-fund companies offer index funds, so review their fees and ensure that they are aligned with an appropriate benchmark. Morningstar is a great resource for finding funds and important fund details such as the fund fees. All you need to do is rebalance your portfolio once a year back to the 50/50 or 25/75. Then, just sit back and concentrate on things other than investing. In this case, it's okay to be lazy!

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