In the part I of this series, we discussed the common retirement accounts (baskets or open boxes, if you will) you can use to do your investing. In this part II, we’ll discuss the investments to put inside of those accounts.
Wall street and some financial advisors make you believe that investing is complicated. Nothing can be further from the truth. Investing is simple if you follow a few basic principles: reduce your risk by widely diversifying your investments including a reasonable allocation between stocks and bonds (called a fancy term, Asset Allocation), maximize your returns by minimizing fees and expenses, and stick with your plan long enough to experience the magic of compounding. Like Jack Bogle said once, “Simplicity is the master key to investment success.” However even though investing is simple, it’s not easy. Why? Because it is mostly a behavioral exercise. It requires a lot of patience and contrarian behaviors.
How Much Do I Invest?
This is one of the commonest questions people ask. How much should I be putting away for my retirement? Like most things in life, there is no one size fits all. How much to save depends on your age when you start investing, your objectives, how much you want to accumulate for your nest egg, how much other incomes (pension, social security) you will be expecting to receive at retirement, how much you have currently saved etc. So it can be quite challenging. There are so many retirement calculators available online that can help you achieve this. Here is one from bankrate.com. However, my philosophy is if you save and invest more, you will have more at retirement. But of course, you should strike for a balance so that you can also enjoy your life now while you’re still working. I feel like the ball-park number should be about 20% of your gross income. It could be slightly less or more. It’s up to you. If you’re on FIRE, you could save 50-70% of your after-tax income. Think that’s impossible? Well, see for yourself here.
Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. There are 3 major asset classes from which to choose your investments and each of these have their own subdivisions.
. By region: United States, Europe, Pacific rim, Emerging markets
. By size: Large capitalization (large cap), mid capitalization (mid cap), small capitalization (small cap)
. By style: growth, value, blend
. By type: Government, corporate, mortgage-backed
. By maturity: short-term, intermediate-term, long-term
. By quality: investment grade, high yield (junk bonds)
. Bank savings accounts
. Certificates of deposit
. Money market funds
Now, some people would include another class of assets, referred as Alternatives. This could include things like commodities, real estate (in the form of Real Estate Investment Trusts or REITs), private equity, hedge funds, managed futures, and derivatives contracts. To keep it simple, I’m not including those in this discussion. There are times when all asset classes advance and times when all of them retreat, but over the long run, they tend not to be perfectly correlated. Proper diversification should be across asset classes (stocks, bonds, cash) and within asset classes so that specific risk is effectively eliminated. It is often said that diversification is the only free lunch in investing.
Every individual will have to determine their own asset allocation based on their goals, risk tolerance and investment horizon. A sample asset allocation would be 70/25/5 meaning 70% of your investments in stocks, 25% in bonds and 5% in cash. If you’re risk averse, you may be more conservative (by putting more bonds relative to stocks in your portfolio) and vice versa. Generally, if you study the history of the stock market and become more familiar and comfortable with investing, you will realize that prior to your retirement, you should have the majority of your portfolio in stocks. J.L Collins, an author and personal finance blogger has made powerful arguments for this in his stock series
Single Stocks or Mutual Funds?
It is extremely difficult to beat the market by selecting your own single stocks. It’s a lot better investing strategy to use only mutual funds (a group of stocks or bonds). Even better is to use only Index funds (passive investing) for your investments. Index funds are mutual funds that track an index. The commonest index most people know is the S&P 500 which is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value. A fund tracking the S&P 500 index is called an S&P 500 index fund. So basically, this fund will behave like the market (S&P 500) behaves. When you own this index fund, you instantly become a tiny owner in all of the largest 500 companies in the US and this provides great diversification. There are also indexes for bonds with index funds tracking those bond indexes. Investing this way is a lot simpler and a lot cheaper and you will likely beat > 80% of active investors without even trying…the lazy man’s way. Actually, you can select just a few funds (or even just one single fund) for all your investing and still come out very successful.
A simple portfolio can just comprise these 3 options:
. Total Stock Market Index Fund (you own virtually all the stocks publicly traded in the US)
. Total International Stock Market Index Fund (stocks from most of the rest of the world, outside of the US are included in this fund)
. Total Bond Market Index Fund (most US bonds, both government and corporate are in this index fund)
These 3 funds are very diversified, yet very simplified and you may not need to own any other funds. The Bogleheads’ Guide to the Three-Fund Portfolio will give you the details. It gets even simpler with all-in-one funds like the Target-Retirement funds (found in most 401(k) plans) or Life-Strategy funds. These funds are fund of funds and can contain the 3 funds listed above or a variety of other funds.
You can keep it simple as above. If you become more savvy and comfortable, you can tweak your portfolio a little more. However complexity in a portfolio does not guarantee success. If anything, it my actually drag your returns. It is also important to see and treat your whole investment portfolio as one: for example, if you have a 401(k), a Roth IRA and a taxable investment account, you should treat them as one. So you don’t have to hold all similar investments in all the accounts. You can hold your domestic stock funds in your taxable account, your bonds in your 401(k) and your international stock funds in your Roth IRA.
If you insist on playing with owning single stocks, don’t let it be more than 10% of your whole portfolio. This is because single stocks are extremely risky and very volatile. A single company, no matter how big, can collapse and become extinct (hello Enron!) but it is virtually impossible for all the companies in a stock mutual fund to collapse and go bust. Even when the whole stock market crashes, the index eventually roars back to life in a few years. The Great Recession in 2008 was the 2nd worst stock market crash in the US (after the Great Depression of the 1930’s) but it only took less than 3 years for the market to recover. So if you never sold the shares in your funds in 2008, you really did not lose anything.
A portfolio’s asset allocation between stocks, bonds, and cash determines the portfolio’s overall risk and return. Historically, stocks have returned more than bonds. You get rich buying stocks. You stay rich buying bonds. So if you want higher return, you put more in stocks in your asset allocation. But you have to be prepared to endure stock market crashes, because a portfolio heavily tilted to stocks can lose up to 50% of their value in severe crashes like happened in 2008. Over time, your portfolio will probably drift from the allocation targets you set. This means your portfolio will have a higher or lower stock-to-bond ratio than you originally intended. Rebalancing is the method used to realign a portfolio with its stated risk and return objectives. Rebalancing simply means adjusting your portfolio to restore its original target allocation. You can do this by selling your winners and buying your losers or by adding more money to your losers without selling your winners.
Rebalancing can be done at fixed times, once or twice a year or every few years, if there’s significant mismatch in your target asset allocation. I generally do ours once a year on New Year’s Day.
Avoid These Investing Mistakes
1. No written plan or Investment Policy Statement (IPS)
To ensure investing success, you need to plan and write it down. Investing without a plan means you’re more likely to make financial wrong turns. Creating an IPS means putting your investment strategy in writing and committing to a disciplined plan. You can review this plan annually or every few years depending on the changes in your life. An IPS can be a single page document. To give you an idea, check out this sample
2. Investing Too Conservatively
Many people are afraid to incur a loss in their investment portfolio. This is one of the greatest impediments for people to invest. It’s not uncommon to find people leave all the money in their 401(k) account in bonds, money market funds or CDs, where the principal values do not fluctuate much. But this means you are cheating yourself from any chance of real long-term growth.
3. Allowing Emotions to Control Your Investment Decisions
People become very brave in a bull market when they keep seeing their account balance grow, month in, month out, but are scared to death in a bear market (a bear market is when the stock market loses >20% of its value). By the nature of investing, you must have bull and bear markets. This is why educating yourself about the history of the stock market helps, so that when that bear market arrives, you don’t allow yourself to cash out all your money from the stock market. We are currently in the longest bull market in history (since 2009, we have been in a bull market). While nobody can time the market, it is guaranteed that the market operates in cycles of bulls and bears. There are typically more bull markets than bear markets and that’s why over the long term, your money grows
4. Chasing Performance
Nothing attracts assets like last year’s winning strategies and nothing destroys wealth as fast. Don’t chase the performance of funds that have had great recent returns. Last year’s hot fund or stock is as likely to do poorly this year. Just stick to your IPS and follow your written plan
5. Ignoring The Impact of Costs
There are several costs associated with investing (expense ratios on your mutual funds, all trading costs, adviser’s fee if you chose to hire an adviser). The commonest one is the Expense Ratio (E.R). These investment costs can erode your returns. Most people don’t see these costs because expenses aren’t specifically broken out on your monthly statements. This is one of the reasons why Index Funds are the best mutual funds for investing because they have very low cost (typically their E.R. are less than 0.2% while most active mutual funds will have average annual E.R of 1%).
Putting it Together
Now, let’s walk through a practical example of setting up your portfolio. For simplicity, I’ll use the 3-Fund portfolio (described above).
Example: Mr. Ronald is a 35 year old, married IT professional who works as a senior manager for a mid-level IT company and makes $160,000 annually including salary + OT + bonuses (and his wife is a stay-at-home mother). Let’s say, he just started investing and has zero money in his retirement nest egg. How should he allocate his money and in which funds should he put them in?
How Much Should He Save?
Using the 20% of gross income, Ronald should save a total of $32,000 towards his retirement accounts.
What Asset Allocation?
Since he is still relatively young and wants to retire at age 65, he can use an asset allocation heavily tilted towards stocks: 80/15/5 (80% stocks/15% bonds/5% cash)
How To Allocate His Money?
401(k): Max it out ($18,500) and put it in an S&P 500 Index Fund, like VFINX (usually available in most 401(k) plans). This is a close approximation to the Total Stock Market Index Fund
Roth IRAs: He can do a Roth IRA for himself and for his wife too (Spousal Roth IRA). Each Roth IRA maximum contribution for 2018 is $5,500, so $11,000 will go into here. In his own Roth IRA, he can place $5,500 into a Total Stock Market Index Fund, like Vanguard’s VGTSX and in his wife’s spousal Roth IRA, he can place another $4,000 into a Total Bond Market Index Fund like VBMFX and $1,500 a Money Market Fund, like VMFXX
Taxable Account: The remaining $2,500 of his 20% of gross income being saved for retirement can go into a taxable account. And it can also be placed in the VGTSX.
So you will have the following portfolio for him:
Stocks: $18,500 + 5,500 + 2,500 = $26,500 or 82.8%
Bonds: $4,000 or 12.5%
Cash: $1,500 or 4.7%
What if John (32) and Stacy (28) both work as primary school teachers and combined make a household income of $80,000? How do they allocate their retirement savings? Same principle: save 20% of gross, or $16,000 (assuming they already are out of debt and have an emergency fund saved). They can allocate their $16,000 as follows:
- Save in their 403(b)s to get to the match, let’s say each saves $2,500 each to get to the match (Total $5,000)
- Then, they should each contribute $5,500 to a Roth IRA x2 = $11,000
- To allocate the funds using the 3-Fund portfolio, they can put $5,500 in His Roth IRA to Total Stock Market Index Fund, put $3,500 into Hers Roth IRA into Total International Stock Index Fund and the remaining $2,000 into Total Stock Market Index Fund. For their 403(b), they can put $2,500 in His 403(b) into Total Bond Index Fund and $2,500 in Hers 403(b) into Total Stock Market Index Fund
- The above gives you an allocation percentage of 62.5/22/15.5 for Domestic stock/International Stock/Bonds
This is a close approximation. You can have different ways of allocating this. Every year, he can go ahead and rebalance his accounts (it’s better if they’re done in the retirement accounts and not the taxable account) to get to his stated AA (asset allocation) as contained in his IPS.
The above is simplified version of how you can invest. There are a zillion other ways to invest but may be much more complex.
Do you have a clear cut method of investing or does this whole thing still appear too complicated to you? Comment below
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