In This Post:
Setting goals helps determine whether to save or invest your money
Above all, diversify!
If you’re new to this, three simple investments is all it takes
Cornered at the Cocktail Party
One of the most common questions I get among friends is “where should I invest my money?”. While I appreciate the desire for a quick, clear answer to this, it’s somewhat akin to asking “what kind of clothes should I buy?”…
The best response (using clothing as the metaphor) probably needs to be adapted to your situation. What do you want to wear them for? What pieces do you already own? What mix are you looking for based on your age and expected timeframe? What is your budget? Why would you ever ask me about clothing?
Anyway, you get the idea. And in any case, I get the sense that people are looking for the silver bullet to fast investment returns. Time to step back and examine a few things.
(By the way, I can’t remember even being at an actual “cocktail party” — isn’t that a term from like the swingin’ 60s?).
Goals Come in Many Forms
What you do with your money has less to do with “how do I get the best returns” than “what do I want to achieve, and what is the best way to achieve it”. I see too many people putting the cart before the horse and wanting to shoot the lights out with some hot investment idea, or at least go right to wanting to put all their savings in some “maximum growth” alternative.
But given that you likely have multiple goals, having a range of planning options is appropriate in choosing the path toward each one. Examples of financial goals may include:
- Shorter-Term Saving — Car, rent, travel, gifts, pay off bills
- Longer-Term Saving — House, education,
- Longer-Term Investing — Retirement, Kids’ College, Independence!
Once you have identified your primary goals, and an approximate amount it will take to achieve them, you can start to craft a plan that puts money into various risk-return “Buckets” (see my tutorial on Planning here), ranging from ultra-safe accounts for shorter-term goals to more growth-oriented (but riskier) investments as the best way to build toward larger, longer-term goals.
Regardless of your choices of investments, DIVERSIFICATION is key. More about this later
A reminder about “time value of money” and the power of compounding
If one of your primary goals is to build true wealth over a period of many years, you must be willing to assume a certain amount of risk and participate in investments that offer the opportunity for growth through the power of compounding (which I will literally beg you to understand in an upcoming post).
It may sound obvious, but a dollar invested today is worth much more at a future point in time than a dollar invested later. However, what most people don’t fully comprehend is that the value of today’s dollar can result in many times the returns in the future by virtue of time acting as a multiplier.
There are many examples I have used to illustrate this, but one simple one is to keep in mind is the “Rule of 72”, which allows you to figure when an investment will double at various rates of return. Just divide 72 by the expected return to get how many years it would take – an investment that grows at 8% will take about 9 years to double, one returning 12% takes just six years to double, etc (get it? – 8 x 9, 12 x 6).
On the other end of the spectrum, a money market savings account yielding just 1% will take 72 years to double! (You may have that much time, but I don’t!)
The “ catch” of course is that an investment that may return 12% is far riskier than the 1% savings account, so some sense of balance (i.e. reality) is needed.
Savings vs Investing, Risk, and Diversification
To understand investment options as they relate to goals, you must think of a continuum where higher return equals higher risk. So-called guaranteed returns may provide a very safe option but have little or no opportunity for growth. Riskier investments may offer the opportunity for comparatively high returns, but certainly without a guarantee.
To this end, think of putting money in a bank account as “saving” and putting money to work in investments that have a growth component as “investing”.
The range of options includes (but is not limited to) something like this:
Diversifying simply means allocating your money across enough different asset classes so that overall returns are balanced throughout different market conditions.
For example an asset mix for someone with a very long investment horizon (say 10 or 20 years, or much more), may be comprised of of 25% cash and 75% growth investments, where the 75% is split among asset classes such as large cap stocks, small cap stocks, international stocks, and real estate. Much more about exactly what these are and how to invest in them a little later in this post.
In his excellent blog ModestMoney, Jeremy wrote a great post here on this very topic — Investment Diversification – 5 Risky Mistakes to Avoid. Check it out!
A note about Indexing vs Individual Stocks
No matter how much you may think you can out-maneuver thousands of investment analysts, not to mention the overall market as a whole, consider that broad market indexes like the S&P 500 have an iron-clad history of performing better than the vast majority of so-called experts (i.e. mutual fund managers, personal investment advisors, etc).
It is simply too difficult, statistically, to consistently identify stocks that will “outperform” the market, given that The Market supposedly has already priced in all available information relative to a company’s future prospects. Thus you may get “lucky” in a stock that does very well, but that is all it really is — luck.
Take a moment to let the following quote sink in from Harry Browne, who before turning to politics a few decades ago spent his entire career advising people on where to invest their money (and read it in the context of this excellent article on “how much luck goes into investing“):
“Almost nothing turns out as expected. Forecasts rarely come true, trading systems never produce the results advertised for them, investment advisers with records of phenomenal success fail to deliver when your money is on the line, the best investment analysis is contradicted by reality. In short, the best-laid investment plans usually go wrong. Not sometimes, not occasionally — but usually.”
Very sobering, and almost makes you want to stop trying altogether! But remember that markets tend to go up over long periods of time. You just need to own a representative sample of broad markets, not narrow ones.
Takeaways So Far
Your guiding principles, if you’re with me so far, should be:
- Start now! Allocate as much as you are comfortable with toward your long-term goals while also being cognizant of your short-term needs. You can never get that power of compounding back.
- Diversify! Identify a diversified range of investments, allocated to different assets classes. Some investments will go down occasionally if your goal is to achieve long-term growth, but with appropriate diversification you are protected against any one investment causing short-term drops in value.
- Get into The Clash, The Replacements, or REM, by starting with the early albums and working your way forward. That way you can truly see how each of these bands developed brilliantly over the years.
(I threw in that last one as a bit of unsolicited bonus advice)
Asset Allocation/ Initial Strategy
Now that you’re primed and in the long-term investing mindset, we’re ready to set a course and make some initial investments. First you can settle on an overall asset allocation, then drill down into specific investments that fit the various categories
As mentioned above, for someone with more than 10 years to invest, a common allocation might include
- 75% equities (stocks) for the growth component
- 25% bonds and cash (to add balance and some downturn protection)
Given that over long periods of time stocks outperform all other asset classes, some even recommend a 100% stock allocation for your first few years (if you are young and have a 30-40 year investing timeframe).
I temper that only by saying stocks have “corrections” (drops of 10% or more) as often as every couple of years, and a “bear market” (drop of 20% or more) at least a couple of times a decade based on history. Having some flexibility to weather the more severe drops and keep some powder dry for when stocks become cheaper is preferable.
This initial allocation should be kept in mind for both the initial investments and subsequent additions to the portfolio. Account “rebalancing” should be considered at least once a year to make sure the overall portfolio maintains these asset splits (see below).
To recap, the first decision in asset allocation is to choose to spread your investments across broad asset classes that take into account the number of years you have to invest and your risk tolerance. As first indicated in the chart earlier in this post, by asset classes we are mainly talking about:
— Fixed Income (Bonds)
— Real Estate
— Commodities (Gold, Oil, etc)
— Other financial instruments (futures, options, etc)
The “core” will consist of mainly Stocks and Bonds. We can discuss branching out into the other asset classes after a certain dollar amount of core investment is achieved. This may differ based on your situation (income, risk tolerance, amount you are able to dedicate to investments, etc), but I would recommend keeping your allocation extremely simple for the first $50,000 or so.
Within Stocks, the decisions revolve around having exposure to different equity markets, comprised of:
— Large company stocks (Large Cap)
— Small company stocks (Small Cap)
— International stocks
— Sectors (Consumer products, healthcare, technology, energy, and lots more)
The initial allocation to stocks might seem a bit boring, since the “core” should mainly consist of 3 or 4 broad investments that give exposure to the top three categories indicated above.
To that end, one might invest the 75% stock portion equally in the following:
Name Symbol/ Description
S&P 500 Index Fund SPY S&P index ETF (Exchange Traded Fund)
Small Cap Index VB Vanguard small company ETF
International Index EFA iShares Europe/Asia/Far East stock index ETF
(Keep in mind I am not affiliated with any of the particular companies behind these investments – and I am not certified to “sell” you any specific investment. You can easily replicate ETFs or Mutual Funds other than the specific ones indicated here, especially since your employer’s retirement plan will likely offer similar, but not the exact same, index funds as part of your choices. Basically all of these broad indexes are by definition diversified).
For the 25% Bond/Cash portion:
You can split this total between a money market fund (whichever one is offered through your brokerage account), and total bond market fund (BND – Vanguard Total Bond Market ETF).
So, for a hypothetical initial portfolio of $20,000:
25% $5,000 SPY
25% $5,000 VB
25% $5,000 EFA
75% $15,000 Stock Allocation
12.5% $2,500 BND
12.5% $2,500 Money Market Fund
25% $5,000 Bond/Cash Allocation
Not to Overlook Target Date Funds
If your main investments, especially during the first few years of your investing experience, are through your company’s 401(k) or other retirement plan, you may be offered (or simply default to) what is called a target-date fund. These have become very popular in recent years and represent a combination of stocks and bonds in one investment vehicle.
The mix of these assets is based on the date in the future that the fund is named after, as an approximation of when you might retire, such that dates further out have a heavier stock mix while closer dates weigh more heavily toward bonds. For example, if you are a 30-year old in 2018, the recommended target date fund for you, based on retirement at age 65, might be a 2040 or 2045 fund (they are usually rounded to 5-year increments).
Different fund companies will have somewhat different mixes, but the idea is consistently that this choice is a “one-stop shop” for your investment allocation. If you have the ability to choose among different target date funds, either within your retirement account or outside it, some tips include:
(a) compare information on what percent of stocks are held both during the first few years and at the retirement date and choose among fund companies (i.e. Vanguard or Fidelity, etc) that you are most comfortable with based on whether you want to be more or less aggressive with the stock mx, or
(b) if your choices are all within a single fund company and you still want to be somewhat more aggressive, select a fund date that is slightly beyond your retirement date. So in the example above you can go to a 2050 or even 2055 fund to generally ensure a higher stock mix.
And these funds may be a perfectly good choice for you, as it likely mimics something like the initial stock/bond allocation I recommend above.
However, I simply prefer to have separate investments in the broad asset classes so you can have more control over making changes to the mix in the future.
After the Initial Allocation
While any new money invested should keep as closely as possible to the overall Stock/Bond allocation above (and within the stock categories), once the portfolio has reached a “critical mass” one can consider some “non-core” investments.
Again, this critical mass is a personal decision depending on what point you are comfortable adding non-core investments.
Some suggestions for these non-core investments are:
Real Estate VNQ Vanguard Real Estate ETF
Emerging Markets EEM iShares Emerging Markets ETF
Technology IYW iShares US Technology ETF
Healthcare FHLC Fidelity MSCI Healthcare Index
Energy XLE Energy Select SPDR
If you are comfortable making this transition beyond the core, an example of a growth-oriented portfolio of $100,000 might be comprised of:
20% $20,000 SPY
20% $20,000 VB
20% $20,000 EFA
5% $ 5,000 EEM
5% $ 5,000 IYW
5% $ 5,000 XLE
75% $75,000 Stock Allocation
12.5% $ 12,500 BND
12.5% $ 12,500 Money Market Fund
25% $25,000 Bond/Cash Allocation
Again, this is only one example of a diverse allocation. There is a universe of possible investments to choose from. In fact there is a mind-boggling list of thousands of specialized ETFs (including things like the Dow Jones-UBS Coffee Subindex – but just because we may share a love of coffee, you don’t need to venture here!). Whatever you end up taking an interest in, just be sure to keep within the broad allocation percentages above.
Taking at Shot With Stocks
Despite my earlier attempt to steer you away from individual stocks, I know it’s tempting to put your money specifically in those companies that you know and love, with visions of incredible runups in stock price akin to the Microsofts, Wal-Marts, Amazons, and Googles of the past.
But for now I would not recommend investment in individual stocks. As great as so many companies are, forecasting their long-term stock prospects introduces a level of risk that does not need to be taken in order to have a diversified, growth-oriented portfolio.
As much as I have been into following markets, and fascinated with individual companies, since I was about thirteen, even my own ventures into individual stocks have about a 50/50 success rate (measured against how I would have done just sticking with broad indexes). My “winners” did great, and my “losers” cost me valuable funds I’d never get back, so proceed with extreme caution.
That being said, once you get into non-core territory, investing in a couple of individual stocks, with the proper amount of research, can add some spice to the allocation. But I stick by a rule of thumb that no single company should comprise more than 5% of your total portfolio.
The only exception may be if you get a sweet deal on your company’s stock, and have extreme confidence in the business – and even then I wouldn’t go higher than 10% of total investments.
Monitoring the Portfolio
You may be tempted to check the balances of your investments frequently online — monthly, weekly, daily? Fine, I actually do.
But you must resist the urge to meddle with them!
You have set an asset allocation for the long-term for a reason — to not let the noise of short-term market fluctuations deter you from your goals. Sure, markets will go down occasionally, not just daily but over periods that can last months. Still, the amount of evaluation and potential adjustment should be infrequent.
I recommend a “rebalancing” of your portfolio about once a year. Either commit to this around the beginning of a new year, or pick a date such as your birthday to do this (for me this happens to be only three days difference — Dec 28 — just giving y’all some notice).
And by rebalancing I mean looking at where market changes may have altered your original allocation. If the market has risen significantly and your 75% stock/ 25% bond allocation is now 80%/ 20%, you may want to sell some of the stock portion and reallocate toward bonds.
Similarly, and this is where you need to fight against human nature, if your stocks have fallen significantly the rebalancing would have you buying more. I know sometimes the hardest thing to do is to commit more of your money to a falling market, but this only ensures that you are buying more shares at a lower price.
When the markets inevitably recover (perhaps not right away, but over a long period of time), you will benefit from long-term trends that have held for the past 200 or so years.
Now Get Started!