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[Written 7/2/2006] Investing can be a dry topic, but having a plan for asset allocation and growth is absolutely essential to financial health and security. I am of the opinion that almost anyone can manage their own investments by understanding and following some simple principles. I have tried to outline those principles here. I take no credit for these ideas, other than for organizing them and presenting them in my own way. I have benefitted greatly from several books (which are identified herein) and some excellent online resources. Hopefully this section will prove helpful to some people. The financial world, while complex, is still bound by simple rules. A basic understanding of these rules and observations can allow anyone to adopt a rational investment approach which requires only minimal effort to maintain. Then one can get back to the business of living life. Click a topic to jump to the section below.. Investing Topics
While I will not attempt to cover such lifestyle financial issues as frugality and budgeting, it should be noted that there are only three ways to reach your saving and investment goals faster:
So assume you have some extra money in the budget - should you invest it? You should start by looking at your whole financial situation - the big picture. If you have existing debt and loan payments, it is crucial to examine the interest rates and tax benefits (if any) of that debt before investing. Think of a loan payment at X% annual interest as the equivalent of a risk-free investment which earns X%. In other words, if you have credit card debt at 15%, paying down that debt is equivalent to investing with a guaranteed 15% return in terms of its effect on your overall financial well-being (net worth). For some debt, such as mortgage debt or student loan debt, you may be able to deduct interest paid from your adjusted gross income on your tax return. You can calculate a rough tax-adjusted interest rate for such debt by reducing the percentage rate by your marginal tax rate. So if your tax rate tops out at 25%, and your student loan debt is at 8%, the tax-adjusted debt rate is 6%. Caveat: This is a very simplistic view and is to be used only for estimation. You may not qualify for student loan or other tax deductions. Similarly, mortgage interest tax deductions are meaningful only after you have surpassed the "standard deduction" in total interest. Still, the goal here is to estimate the interest rates on your debt. My personal comfort level with debt would have me paying down any debt above an effective rate of about 6% before investing. This is based on the current financial environment (July 2006) and my own biases. A guaranteed 7% return would be an attractive investment, and therefore a loan at 7% or higher would be a good place to send extra money before committing it to investments. In addition to paying down high interest debt, it is important to have an emergency fund. Most financial gurus will advocate having a minimum of 3-6 months' worth of your expense set aside to handle unexpected events, such as losing your job, illness, home or auto repair, legal expenses, etc. If you don't have an e-fund, then you should either commit to building one before investing, or you should contribute to one (with the goal of building it to a suitable level) while you are investing. You can place your e-fund money in a high yielding savings or money market account. Companies like INGDirect, EmigrantDirect, HSBC, and others offer money market accounts earning upwards of 5% interest, with no risk (again, as of July 2006). This is an appropriate home for e-fund cash. Here are a few other random notes about personal finance, before we move on to investing. If you decide to pay off debt first, in general it is best to attack the highest-interest-rate debt first. Also, note that your credit score (sometimes called FICO score) will affect the interest rates that are offered to you. You can check your credit report once annually from each of the three major credit agencies at annualcreditreport.com. Your credit report is increasingly being used to assess your financial habits - in fact, your car insurance premiums likely factor this information in right now. It is important to keep clean credit, and to check your report periodically to make sure that there are no erroneous entries. One strategy is to use the website above to check your credit at each agency in a spread-out timeframe, staggering the three checks throughout the year. Finally, I think it is important to look at a car as a large financial burden. This is a depreciating asset, a huge expense at both purchase time and to maintain, and a large component of many people's budgets. It is likely best to buy a reliable car and keep it for a long time. Once your car payments end, consider continuing to make payments - to yourself. Put your monthly car payment into a high-interest account, and you may find that when it comes time to buy a new car, you can pay for it in cash. If debt is not a problem, your e-fund is covered, and you are ready to invest, read on.. For many people, the idea of controlling one's own investments generates a lot of anxiety. This is natural. Finance can be complex, the stakes are high (your future!), and we are bombarded with advertising and often contradictory advice. However, there really is no escaping the responsibility of owning your investments and the decisions affecting your investments. Consider this. You decide that you should be investing in stocks, but you don't know which stocks to choose. You don't want that responsibility, so you decide to invest in a mutual fund where a fund manager will choose the stocks. But how do you choose the mutual fund, and how do you know to trust a given manager's decisions? You may decide to enlist a financial advisor to take care of your assets, but again you have the conundrum - how do you know who to choose, and whether you can really trust this person? Will your financial advisor invest your assets in a way that is consistent with your goals, your risk tolerance, your dreams? No matter how you choose to approach investing, the fundamental decisions are yours to make - you can't escape it. But you can educate yourself to make sound decisions. If you do choose to enlist a financial advisor, you must be aware of the inherent conflict of interest between many advisors and your net worth. Many advisors are compensated by selling certain high-cost funds to investors. In fact, it doesn't even matter if the funds they are selling are high in cost - the mere fact that they will be compensated for selling you certain funds and not others should indicate that they may not make the best choice for YOUR investments. In addition, some advisors make commissions whenever funds are purchased. This gives them incentive to move your funds from place to place, perhaps following the latest Wall Street trend, generating more commissions and draining your investments. There are "fee-only" financial advisors, who only collect a flat fee from their clients and are not compensated by mutual fund companies or brokers. If you do choose to enlist a financial advisor, you should seek out one such as this and be sure that his investment philosophy is in sync with your own. In my opinion, your best approach is to take control of your own investments. There are a wealth of excellent, low cost options available to investors both large and small today which render expensive brokers and advisors irrelevant. Before we go on, I want to acknowledge the sources that have contributed greatly to my own understanding of investing. The three books listed below are widely considered to be some of the best at explaining the index investing approach, with heavy emphasis on asset allocation. I have read and recommend them all.
As an aside, I want to mention that I believe the status of "millionaire" is within almost anyone's reach in the United States. Living below your means, consistent investing, and some discipline can yield amazing results. One more book recommendation is The Millionaire Next Door (Thomas Stanley, William Danko). This book goes into detail about the typical characteristics of American millionaires. You may be surprised to see how many of them are blue-collar types, or small business owners. Many of the highest earners are also the highest spenders, and that is not a recipe for long-term wealth. Anyway, the book is interesting and can serve as a source of inspiration. My writing is intended to be an introduction to these topics. In order to adopt a plan and have the fortitude to stick with it when the market is down, you will really need to believe you are doing the right thing. You'll probably have to do a little reading to convince yourself to stay the course. The worst thing you can do to your portfolio is panic and sell when things are not going well. When we talk about investments, what do we really mean? Where can you park your money? Here are some common assets: stocks, bonds, CDs, real estate. Some other options are simply aggregations of these assets, like mutual funds, ETFs, and real estate investment trusts (REITs). Here are a few very quick definitions before we continue:
In addition to looking at the types of investment available, we should take a look at the investment vehicles available - the types of accounts we can use to invest.
With all of these investment vehicles available, where should you put your limited funds? In general, you want to put money into tax-advantaged accounts, since avoiding taxes (or at least deferring them until later) tends to maximize your wealth. There is a fundamental distinction between the 401(k)/403(b) style account (hereafter just referred to as a 401(k) account) and the Roth IRA. Taxes are extracted up front in a Roth IRA, and no further taxes will ever be due. A 401(k) is tax-free when you contribute, and later taxed as ordinary income when you withdraw funds. If you assume an identical tax rate now and later, this timing is actually irrelevant. You can try this: assume $1000 invested, growing at 10% per year for 30 years. Furthermore, assume a current tax rate of 25% and a "retirement" tax rate of 25%. Due to the commutative property of multiplication, it doesn't matter which order you apply these factors - you end up with the same amount of money. Therefore, the argument between 401(k) accounts and Roth IRA accounts boils down to a prediction of whether your tax rate now is lower or higher than it will be when you withdraw funds. If you expect your retirement tax rate to be higher, the Roth IRA is a better deal (pay the taxes now at the lower rate). Otherwise, the 401(k) is a better deal. I think it is wise to contribute to both, if you are eligible. This gives you flexibility later in life to draw funds in the most tax-efficient manner. Note that some employers offer a "match" of funds contributed to a 401(k). Usually the first X% (often 6%) of the employee's salary will be matched if the employee contributes it to the 401(k). It is almost always a good idea to contribute enough to realize the full match offered by the employer - this is as close to "free money" as it gets (and note that such companies typically do not offer a pension, so you had best make the most of any investment opportunity offered!). Once your tax-advantaged accounts are maxed out (or if you are not eligible for any), you will have to invest in regular taxable accounts. It is important to put "tax-efficient" assets in taxable accounts so that your gains are not eaten away by taxes. I will come back to this later when we discuss asset allocation. In general, just be aware that tax considerations are important to investing, and you can thank the government for the complexity inherent in managing different assets across multiple accounts with differing tax profiles. This section contains some of the guiding principles of investing, and it is these ideas (combined with basic logic) that really determine the "how" of rational investing. Some of these ideas are straightforward (the compounding of interest is powerful!) and others are the results of extensive empirical studies (the failure of actively-managed funds as whole to beat market averages). In any case, this is an important section when it comes to the development of an investment approach. Compounding is powerful. Albert Einstein once said that "The most powerful force in the universe is compound interest." When your investments make gains, and those gains make gains, and then THOSE gains grow, well - you get the point. Time is a powerful ally and this means that the SOONER you can start your money growing, the better off you are. You can view any chart of compound interest growth to see this. Here is one example. If you invest $1000 and it grows at 10% annually (with no further contribution), here is what you will have after so many years:
Time horizon determines investment choice. The length of time until you will need the funds invested is important for determining the proper type of investment. If you are saving for a house downpayment or other purchase within the next 5-7 years, your money should not be in the stock market. Stocks are risky over the short term, but are an excellent investment over the long term (10+ years). Short-term savings should be in safer vehicles like CDs or maybe bonds. Retirement savings can go into riskier assets where a longer timeframe gives them time to recover from market swings. Divide investments into logical buckets. The prior rule implies the need to separate invested dollars into different buckets, at least logically, based on time horizon. Money saved for a child's college expenses may need to be in a different investment, and possibly a different account, from retirement savings. Determine which buckets are appropriate for your investments. Risk and reward are inextricably related. The safest investments will provide the lowest returns, on average. In order to earn higher returns, some risk must be taken. This relationship between risk and reward is a fundamental concept in economics and investing. The good news is that by diversifying and owning different types of assets, you can mitigate some of the risk and achieve solid returns. Note that, even for safe investments like CDs, there is still inflation risk. Even if you have a guaranteed 5% return on a CD, there is no guarantee that the real value of your money will keep pace with inflation. Inflation risk is sometimes ignored by super-conservative investors who fear the volatility of stocks. Buy low, sell high. You've heard this before - you want to buy "low" and sell "high" when you invest. But how do you know what is "low" and what is "high". How can you time the market or the price of an asset properly? Really, there is no reliable way to do so. However, a strategy of dollar cost averaging with consistent, regular purchases in the market and asset rebalancing will provide an inherent buy low/sell high bias to your purchases and sales. I'll explain this later. Expenses matter. All investors, taken as a whole, will perform exactly as the market performs (since they make up the market in aggregate). The actual money available to any given investor, however, is his performance MINUS the expenses incurred. When we look at investing in mutual funds and ETFs, it is imperative to look at the costs of owning the funds. It is important to minimize expenses - even 0.5% difference in management costs will make a big difference over decades of holding the fund. Taxes matter. We've already taken a look at the various types of accounts you can hold. Taxes are a drain on your returns, and you should seek to shelter as much of your portfolio as you can via 401(k) accounts, IRAs, etc. Furthermore, you should hold tax-inefficient assets in your sheltered accounts, and tax-efficient assets in your taxable accounts. Tax-inefficient assets are assets which give off current income in the form of interest, dividends, or capital gains due to frequent selling in a fund. Tax-inefficient assets include CDs, bonds, REITs, and some stock funds (typically small cap funds). Tax-efficient assets typically give off little current income, and instead grow over time via capital gains. Index mutual funds which hold stocks are typically tax-efficient. Some fund companies like Vanguard also offer "tax-managed" versions of some of their funds which are good options for a taxable account. Asset allocation is the single most important aspect of your portfolio. One famous economic study indicates that over 90% of the performance of a given mutual fund is accounted for by the overall asset allocation of the fund. The particular stocks or bonds chosen by the fund mattered very little - it was the overall makeup of the fund that predicted most of its performance. This is a key idea and demonstrates that the fundamental choice we must make with our portfolios is overall asset allocation. The specific funds chosen to implement the asset allocation are much less important (provided you seek to minimize costs, take taxes into account, etc). Active management has a terrible track record. Actively-managed mutual funds incur higher expenses (paid to management and staff) in order to try to choose superior stocks, bonds, etc and beat the market's performance. The track record of actively-managed funds, after expenses are taken into account, is abysmal. Depending on which study you look at, 75% to 90% of active fund managers FAIL to beat simple market averages. This is astounding! Your chances of picking the fund with the hot hand are not good. The rational choice is to minimize costs and pick the market average itself - a low-cost index fund that just matches the market. In doing so you will beat a significant majority of individual and professional investors. Being average isn't so bad after all! Most examples of outperformance are luck. At any given time, there are some mutual funds doing really well. They are beating market averages and the media is touting them as the greatest thing since electronic banking. Should you buy these funds? No way. Due to simple chance and random variation, some funds will always do better than average. If this really is due to chance and not manager skill, we would expect that outperformance to cease, and for these funds' performance to "regress to the mean". This is exactly what we see in practice. The currently hot funds are actually slightly more likely to UNDERPERFORM going forward than to outperform (in the long term; in the very short term, there may be a momentum effect). The strategy of "chasing performance" is a failing strategy, yet it is probably the most common way individuals choose funds. They look at the 1-year, 5-year, 10-year, and lifetime performance of a fund and they are happy if it looks high. Never mind that outperformance is probably due to luck, and that a single good year at the end of the time period will inflate the value of the 1-year, 5-year, 10-year, and lifetime returns of a fund. Asset performance is cyclical. Gold is hot right now, international emerging market stocks look good, the energy industry is doing well, healthcare looks strong. Should you place all your money in these hot sectors? Not necessarily. Asset performance is extremely cyclical, and it is not possible to predict the "hot" assets from year to year. The best approach is to own a piece of ALL the major asset classes, according to your own desired asset allocation. Here is a link to a "periodic table of investment returns" which demonstrates the incredible variation of asset returns from year to year. Do you care to bet your retirement trying to predict the "hot" asset class after seeing this chart? I hope not. Callan Periodic Table Of Investment Returns. As previously stated, the most important decision you can make about your portfolio is your overall asset allocation. Let's take a look at the major asset classes from a very high level. Here they are:
Usually people like to break these asset classes down further. For example, stock can be divided into domestic/foreign, or divided by market cap (the size of the company; the total worth of all outstanding stock), or divided by financial metrics such as the infamous growth/value distinction. Growth stocks are usually highly valued and expected to sustain higher than average growth to justify that valuation (as often measured by the P/E, or price to earnings, ratio). Value stocks are often valued rather low due to low growth prospects or other issues. Here is a more detailed breakdown of asset classes. Note that you do not need to get this detailed to construct a diversified portfolio.
[This is incomplete! Here is the outline for the rest..]
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