If you have some interest in managing your investments beyond target date funds, then this post is for you. Just FYI, I am not a financial professional, so I’m writing how I view investing and am providing general information that I believe is accurate, but I recommend you seek professional advice and education before making any changes in your own finances.
Creating a Portfolio
Now let’s go back to DIY investing. Let me be clear, you will have a difficult time doing much better than a target date fund, but it is always good to have more knowledge and is satisfying to craft your own portfolio beyond target date funds. To keep it simple, you can invest in stocks, bonds, or a money market account. There are other investment options out there such as commodities and real estate. Real estate is a different beast as it is usually not easy to convert quickly to cash and often requires much more effort. Putting together what you want to invest in is called creating a portfolio. You want a portfolio that is diverse or has a piece of each type of investment so as to avoid the emotional rollercoaster that comes when one type isn’t doing very well. Most retirement or financial independence portfolios invest in a mix of stocks and bonds with a money market fund for the emergency fund/cash part.
Stocks = Ownership of a Business/Company
Stocks are just buying part-ownership in a company. Stocks make or lose money based on the market value your piece or share of the company. Stocks also make money as companies pay their earnings back to their owners (you the stockholder) and are call dividends. The USA has approximately 3,600+ common stocks available. Internationally there are an additional 6,383+ non-USA common stocks.
How do you decide which stocks to invest in? It’s simple. You don’t. You buy a piece of every stock thus guaranteeing you’ll do as well as the market as a whole. Most people who pick stocks for a living do worse than the market as a whole. It really is a full-time job investing in individual companies. There’s a lot of crap to wade through to figure out the reasonable value of an individual company. If that sounds fun to you, then by all means learn and go ahead. Many people just invest in companies that they like or that they perceive are doing well. This is speculating and almost guaranteed to cause you financial loss. Most professionals don’t do better than the market as a whole and those that do usually barely do better. So I only personally buy the stock market as a whole. The only way to buy a piece of every stock without having billions of dollars is to buy index funds. Index funds are advertised as mutual funds or ETFs. Not all mutual funds or ETFs are index funds so be careful.
Buying Index Funds
A couple of things to look out for when shopping for index mutual funds or index ETFs are to ensure they are really total market index funds. You also want to look at the fees for buying and owning the fund. You should NEVER pay a fee for buying a mutual fund although you may pay a trade fee for buying an ETF. Vanguard does not charge you a fee for buying their ETFs or their mutual funds. Also you should buy index funds that have a low expense ratio or cost of owing the fund. NEVER buy a fund with an expense ratio greater than 1%. The beauty of an index fund is that it is cheap to run and is therefore cheap to own. Vanguard and Fidelity both have index funds with expense ratios less than 0.04%. I personally like Vanguard as they are a company that is owned by it’s fundholders meaning they are not trying to make money off you like Fidelity or the multitude of other financial companies. Other companies still offer great, cheap index funds so don’t rule them out but be careful. Often the retirement plans at work are through a specific company, so you have to pick from a limited range of options. Thankfully it seems most of these employer-sponsored plans offer index funds. Unfortunately the expense ratio is usually still higher than you could get elsewhere. If a total market index fund is not available, then invest in an S&P 500 index fund. The S&P 500 is an index of the 500 largest companies in the USA. The S&P 500 covers 85% of the total US stock market, so it’s still a solid index fund to invest in.
Bonds = Loaning Money to Business/Company
Remember I said there were a couple of components to invest in? Stock obviously are an important component. But the other major component is bonds. Nobody talks about bonds in casual conversation except maybe financial nerds. Why? Because compared to stocks, bonds are boring. Nobody gets wealthy investing only in bonds except the brokers who sell them. A bond is loaning your money to a company or government for a set period of time and in return they will pay you a set amount of interest every year. After the agreed upon period of time, they return your money back to you. Thankfully there are bond index funds you can and should invest in rather than individual bonds. The bond funds that seem best in my opinion for most DIY investors are either a total bond index fund or a intermediate term treasury index fund. There’s a lot more that goes into bonds, but basically they are a safer place to invest your money with a lower return than the stock market.
The Zig and the Zag
Why even bother with bonds? Some people don’t bother with them. J.L. Collins in his book The Simple Path to Wealth makes a compelling argument for investing 100% in the stock market. I like bonds for one main reason: they tend to zig when the stock market zags meaning bonds do well when the stock market is crashing. In my opinion the value of having bonds is mainly emotional. Bonds help ease the emotional rollercoaster when my substantial investment in the stock market shrinks by 40-50%.
Basic Premise of Investing
A basic premise of investing is to sell high and buy low. That premise generally goes against our gut urges. It is human nature to have a strong urge to sell your investments when they are not doing well. That urge is amplified when your investments are shrinking. While in the long run stocks perform much better than bonds, when stocks are doing poorly it is nice to have the emotional booster from your bonds. It seems bonds tend to do quite well when stocks are doing poorly. We always want to buy stocks when they are hot and sell them when they are doing poorly. If you have already decided in advance that you are going to have a certain ratio of stocks to bonds such as 80% stocks to 20% bonds then you prepare yourself in advanced for the emotional roller coaster when the stock market crashes.
The ratio of stocks to bonds that you have predetermined is called asset allocation. Having an asset allocation allows you to sell when something is high and buy when either stocks or bonds are low. Setting an asset allocation ahead of time, you have already decided what you’re going to do no matter what happens in the market. You get emotional stability having a plan. How does asset allocation work in practice? For every $100 that you want to invest, you buy $80 of the total stock market index fund and $20 of the total bond market index fund. Once a year you compare your ratio of stocks to bonds and either sell some of the higher performing funds and invest more into the lower performing funds until the ratio is back to where you want it to be. Target date funds do this for you automatically.
The Perfect Asset Allocation
A problem I have been wrestling through is my own asset allocation. From what I can discern, there is no perfect asset allocation. It seems that asset allocation is determined more by psychological and emotional comfort more than anything else for long term investors. If you are retired or near retired, then you will obviously want more bonds in your asset allocation to preserve your nest egg. The most rational asset allocation is 100% stocks as historically stocks have always outperform bonds far and away over a 10-20 year period. But that doesn’t mean it’ll always happen in the future although it is highly likely in my opinion.
I feel that having a predetermined plan will help me be a better investor in the future and not make emotionally driven choices. I feel also like it would be very difficult to continue investing in 100% stock portfolio plan when I know that most investment advice recommends holding bonds. I also feel like having a bond to stock ratio allocation will give something to distract me when the market is not doing well as I will be selling off bonds to rebalance my portfolio. This is exactly what I should be doing, selling high and buying low. Having a ratio of bonds to stocks even if it’s small will help facilitate this basic premise of investing.