A reader writes in, asking:
“At what level of money does passive investing make the most sense? Is there a ‘sweet spot’ so to speak in terms of portfolio size or income? How would the strategy have to be adapted to work at different levels?”
Firstly, there’s no sweet spot. Passive investing is a prudent choice across the full spectrum of asset and income levels — as soon as you reach an income/asset level where investing becomes relevant in the first place, that is.
Passive investing makes sense for the new beginner who is just getting started with small amounts, and it makes sense for huge pools of money such as university endowments.
The primary reason why passive investing is a reasonable choice at all levels is that it’s based on a mathematical truism — one that applies regardless of the amount of money in question. Specifically, as long as the average passively managed dollar incurs lower costs than the average actively managed dollar, it is mathematically certain that passively managed dollars will on average outperform actively managed dollars. (If you’re unfamiliar with that concept, I’d encourage you to read William Sharpe’s wonderfully succinct paper “The Arithmetic of Active Management.”)
What Does Change at Higher Income or Asset Levels?
Having said the above, it’s important to note that the implementation of a passive investment philosophy is somewhat different at different income/asset levels.
For example, tax-efficient investing strategies are very different for the person whose entire portfolio consists of a $5,000 Roth IRA than for the person with a seven-figure portfolio, most of which is invested in taxable brokerage accounts. And they’re different still for investors whose portfolio size is such that they have to be concerned with the estate tax (with its 2016 exclusion of $5.45 million, and twice that for married couples). But in each case, it’s perfectly prudent to use a passive portfolio of boring index funds.
In addition, the asset allocation decision is somewhat different at different levels of assets/income. Specifically, when your total assets are low relative to your living expenses, you have less flexibility with your asset allocation. That is, you cannot afford to have a risky allocation if you may need this money in the near future (i.e., if your retirement savings are currently doubling as an emergency fund). But again, a boring passive portfolio is still a good idea.