Simple Strategies for Investment Success
September 29, 2011Last week, I shared some pretty sobering numbers about how little the average investor has actually been earning in the stock market over the last 20 years. This is largely because investors tend to jump in and out of the market at the worst possible times, reacting largely based on emotion.
The good news is that there are some pretty simple ways to avoid this fate.
Buy the Market.
One strategy would have been to simply buy and hold a diversified stock index fund. An S&P 500 index fund would have earned you over 9% a year over the last 20 years, instead of the less than 3% that the average investor actually earned. This would also have the additional benefit of saving you from a lot of fees, expenses, and hidden trading costs that you find in actively managed stock funds. That’s why low-cost index funds have historically outperformed actively managed funds about 80% of the time. Pretty nifty huh?
The main downside of this is that you’d have practically 100% of your portfolio in stocks and most people just won’t be able to sleep at night during those inevitable downturns. Even if you can withstand all those ups and downs, it’s not necessarily a good idea to take that much risk, especially as you get closer to retirement. After all, there’s no guarantee that the U.S. stock market will continue to do as well as it has.
Stay Out of the Market.
If you really hate risk, you could go to the other extreme and put all of your money in inflation-index treasury bonds like TIPS or i-bonds, that are guaranteed against default by the federal government and are protected from inflation. If you buy ones maturing at different times and hold them until maturity, you don’t have to worry about selling them at a loss either. An economist named Zvi Bodie actually recommends a strategy like this in his book, Worry-Free Investing.
So what’s the downside? One problem is that you may not earn enough to reach your goals, especially with interest rates at historic lows. The other risk is that the government may understate inflation. There’s even a site called shadowstats.com that tracks what it claims to be the “real” inflation rate. Even if you don’t buy into the idea that the official inflation rate is manipulated, it’s easy to see how retirees in particular are experiencing a higher than normal inflation rate since they spend a higher percentage of their income on medical expenses, which are growing faster than inflation. The final problem is that these bonds aren’t usually offered in the retirement plans that hold the bulk of people’s savings.
Find a Balance.
To get more of a balance, most financial advisers recommend that you put together a diversified portfolio of stocks, bonds, cash, and maybe alternative investments like commodities or real estate, and then rebalance it periodically. How do you know how much to put in each type of investment? You can take a risk tolerance quiz like this one and use the guidelines that go with your score. (Just don’t keep changing your risk tolerance based on what the market is doing.)
The trick is to then rebalance it periodically. For example, let’s say your plan is to have 60% in stocks and 40% in bonds. When (not “if”) the stock market goes down, you may end up with say 50% in stocks and 50% in bonds. Instead of selling stocks like most people do, you’re better off re-balancing back to 60% stocks and 40% bonds. That means moving money out of bonds and buying more stocks. When stocks do well and you have 70% in stocks, you would take some of your money off the table and rebalance back to 60% again. By doing this each year, you end up buying stocks relatively low and selling them relatively high. This can reduce your risk and even potentially increase your returns incrementally over time. Some retirement plans make this really easy with an auto-rebalance feature that does it for you.
To make it even simpler, you could also just pick a one-stop shop asset allocation fund. There are two main types. Some used fixed allocations based on a certain risk tolerance (conservative, moderate, or aggressive) and are called balanced or lifestyle funds. Others, called target-date retirement funds, change their allocations to be more conservative as they get closer to the target date. Either way, these funds are designed to hold all of your portfolio since they are fully diversified and rebalanced for you. You can set it and forget it.
Using these simple strategies will help you beat the average investor and get closer to those 8-10% long term returns. But I think there might be ways to do even better. Stay tuned…