All You Need To Know About Investing In 3 Simple Steps
April 16, 2015Whenever I talk to people about investing, I find that most people fall into one of two groups. One group feels that investing is too complicated for them so they want to hire a professional to manage their money for them. The other group is make up of active investors who try to time the market with statements like “I think the market is too high to get in right now” or “I’m going to wait for prices to come down before I buy” and/or pick stocks or actively managed funds that they think will outperform the market. The problem is that there’s no evidence that market timing or even actively picking stocks really works (unless monkeys or cats are doing the picking). If the vast majority of professional money managers continue to underperform the market with these methods, do you really think you can in your spare time?
The reality is that investing is a lot simpler than it may seem. This should be good news for both groups. The first group can save money on investment commissions and advisory fees. The second group can save time (and stress) from not having to research stocks and follow the market. Both groups can also almost certainly make more money by just following these 3 simple rules:
1) Make sure you’re properly diversified. As you’ve probably heard countless times, don’t put all your eggs in one basket. The main baskets are three types of assets: cash, bonds, and stocks.
How do you know how to allocate money between each of those assets? Any money you might need in the next 5 years should be kept in cash. For longer term goals, put more in stocks if you’re more aggressive/comfortable with risk and less if you’re more conservative. There’s no one right way to do this but here are some models you can use to diversify your investments from the non-profit American Association of Individual Investors. It also includes a link to a survey to help you determine how conservative or aggressive an investor you are.
Of course, you also want to make sure you’re diversified within each of those asset classes too. One of the biggest mistakes you can make is to put more than 10-15% of your overall portfolio in any one stock. No matter how good a company it is, any stock has the potential of going to zero and never coming back. That’s much less likely to happen to a diversified portfolio of at least 25-30 stocks from different sector and virtually impossible to a fund with hundreds of stocks. You’ll also want to diversify bonds because they have risks too.
2) Minimize your costs. Once you know how you want to diversify your money, you’ll want to purchase those investments as cheaply as possible since that’s been shown to be the most reliable way to maximize your returns within each asset class. To do that, you need to understand several different types of costs that can eat away at your returns:
Commissions. This is what you pay an advisor or broker when you purchase an investment. These commissions are routinely as high as 5.75% of what you invest in a class A load fund. You can minimize these by avoiding mutual funds with load fees and by purchasing investments at low cost discount brokerages like Charles Schwab, Fidelity, TD Ameritrade, Scottrade, and Vanguard.
Fund Costs: If you purchase a fund, this is the fee that you pay each year to manage, administer, and market the fund. According to the Investment Company Institute, the average stock mutual fund charged .74% in 2013. The easiest way to reduce these fees is to use index funds, which charge an average of just .12% for stock index funds versus an average of .89% for actively managed stock funds. Of course, you can pay 0% in expenses by investing in individual stocks and bonds but that generally takes more effort.
In addition to the expense ratio, there are also trading costs every time a fund buys and sells investments. While they’re not disclosed as a fee, they have been estimated to reduce your returns by another 1.44% a year. You can estimate trading costs by looking at a fund’s turnover ratio, which measures how often it trades. Index funds tend to also have lower trading costs since they simply track an index and don’t trade as often.
Taxes: The best way to minimize taxes is to use tax-sheltered accounts like a 401(k), IRA,and 529 college savings plan as much as possible. If you have a taxable account, you can reduce taxes by avoiding tax-inefficient investments like REITS, high turnover funds, commodities, and taxable bonds (all better off in tax-sheltered accounts), holding investments for more than a year before you sell them, and selling investments that have declined in value and using the losses to offset other taxes. (This is called tax loss harvesting.)
3) Re-balance periodically. There’s good news and bad news when investing in stocks. The bad news is that your stocks will almost always go down in price at some point. The good news is that as long as you’re well-diversified (see #1), they will almost certainly come back. Now, it may take a few years. For example, it took 4 ½ years for stocks to recover after the 1929 crash in real terms and about 4 years to recover after the financial crisis in 2008.
That’s why you don’t want to invest money you might need in the next 5 years in stocks (see #1) but for longer term goals, these downturns are actually opportunities to buy more stocks while they’re low. No, that doesn’t mean you should try to time the market (see #2). All you have to do is re-balance your portfolio at least once a year.
Here’s how that works. Let’s say your target portfolio based on your time frame and risk tolerance (see #1) is 60% stocks and 40% bonds. If the stock market does really well like it has in the last few years and your stocks grow to 70% of your portfolio, you may feel pretty happy. But now you’re taking too much risk.
What you’ll want to do is move enough money from stocks to bonds to bring your portfolio back to the 60%/40% split. By doing so, you’ll be selling some of your stocks while they’re relatively high and taking some of those profits off the table. By doing this each year, the higher stocks go, the more of them you’ll sell.
When stocks eventually fall in value, you might have only 50% in stocks. Instead of bailing out of stocks or refusing to even look at your account balances, see this as an opportunity to buy stocks at a discount. By re-balancing, you’ll move enough money from bonds to stocks to bring you back to the 60%/40% split. The lower stocks go, the more you’ll buy.
At the very least, re-balancing will keep your risk level on target and prevent you from bailing out of stocks during the next downturn. At best, it can even enhance returns by forcing you to buy low and sell high. As Warren Buffett put it when he was asked how to become rich through investing, the secret is to be fearful when others are greedy and greedy when others are fearful.
So what does all this mean? You don’t need to become an expert in the stock market to be a good investor. All you need to do is determine how to diversify your money between the different investment categories based on your time frame and risk tolerance, choose the lowest cost options available to you in each category, and re-balance your portfolio at least once a year. Do those three things and you’ll be way ahead of most other investors. Next week, we’ll discuss some new online tools that you can use to simplify this process as much as possible.