When you were little, you put your spare change in a piggy bank.
When you became a teenager, maybe you saved your allowance so you could spend it on clothes or electronics or gas money.
When you got to college, perhaps all of your money went to your sorority or fraternity.
No matter what you did with your spare change as you grew up, you certainly knew the importance of collecting it, saving it, spending it, or squirreling it away for future use. There are plenty of no-brainer choices about where you do not want to put your money.
Your extra cash doesn’t belong in mattresses, the freezer, holes in your backyard, or the “new venture” your neighbor has pitched. I get why some people go the conservative (the mattress) or aggressive (the new venture) route. Either they have no tolerance for risk at all—and they want to make sure that they never lose a cent of their nest egg—or they have wide eyes and open hands, putting their hope (and their nest egg) in a “sure thing” that is everything but.
- Neither approach is smart financially. In either scenario, you’ll likely lose out—either by not maximizing your financial opportunity or by actually losing everything you have.
Now that you’re older, you still have the same choices—you take what you earn, you pay your bills, and then you have enough left over so that you have some choices about what you can do with it.
You can (unwisely) spend it all.
Or you can decide to save and invest.
That’s the smart choice—because that’s where you earn money by doing virtually nothing, that’s where you build financial security and freedom, and that’s where you learn to get to where you want to go faster than you ever could have imagined.
After all, that’s the entire point—investing is about giving yourself financial independence now and in retirement. That’s why we do it, that’s why we need to understand the basics (or hire a trusted manager to help us), and that’s why we need to be able to make decisions about investing. Investing gives us a richness not just in terms of dollars and cents, but also in the security to be able to spend our money on what we want in life. We save and invest to make ourselves comfortable, decrease our stress, and get the most out of life.
As my favorite professor at the Wharton School of Business at the University of Pennsylvania, Richard Marston, says: “Saving is a necessity, not an afterthought.”
What makes it even trickier is that, for do-it-yourself people, there’s always a level of angst when the market fluctuates and investments move up and down like an ocean tide.
You wonder, “Is my portfolio doing poorly (or well) because of something I’m doing or because of natural circumstances regarding how the economy is working?”
That angst–or simply the question–is at the center of whether you take control of your own investments or trust them in the hands of professionals.
I certainly think you always are in better hands with a trusted professional who is trained and smart when it comes to investing, but I know some people prefer tackling issues on their own.
No matter which route you decide to take, you want to be educated about investment basics so that you can handle issues yourself or be more aware of decisions that your advisor makes.
We’re not going to tackle advanced issues here but rather talk through some of the most popular questions that my clients ask me to help give you a framework for how investing should work.
When it comes down to it, the main question is this: Where do you put your money?
- Investing is an area where you have to come in with a balanced, smart strategy—making sure you take enough risk to allow your money to grow, while not being so volatile that you end up with a portfolio of zeroes, with no number in front of all of them.
I want to help you navigate the often tricky waters of investing. This isn’t intended to be an encyclopedia of every investment option there is – there is plenty of long, mundane material that you can go through if that’s what you’re interested in.
The Foundations of Investing
Unless you really love investing and are going to watch it every day–and feel you have talent at it because your livelihood depends on it–I think most people should be turning to pros for professional wealth-management help.
By doing things this way, your trusted team of advisors can really deal with the day-to-day decisions and details of what will make you the most money, with the appropriate level of risk.
The other advantage is that a professional can help you weather storms. Most people don’t have the guts to stay in bad markets for the long haul, and an advisor can help give you context and frame the cost/benefit analysis when the market ebbs and flows. “Getting out at the wrong time” is one of the biggest mistakes do-it-yourselfers make, and having someone you trust helps assuage the fear and take the emotions out of investment decisions.
Where do we start? The most logical place is just making sure we’re all on the same page when it comes to the why.
- Why do we save?
- Why do we set aside income now for future use?
My favorite example comes from Professor Marston, who uses the analogy of a squirrel storing nuts to make the point. In his book, Investing for a Lifetime, he writes:
Let’s imagine a squirrel is only concerned about the next 12 months and that it lives in a very cold place where winter lasts for six months. Then a good plan would be to “squirrel away” some nuts. The squirrel would like to eat one nut per day. To store up enough nuts for the winter, the squirrel has to find two nuts per day and save 50 percent of them.
At the end of six months, the squirrel will have 180 nuts saved (i.e., half of the 360 days in a squirrel year)—just enough to last the winter. A 50 percent savings rate is very high, but the squirrel does not want to run short of nuts late in the winter… For the first six months, the squirrel steadily builds up its store of nuts. Then when winter sets in, the squirrel can sit back and consume them. By planning wisely, the squirrel can eat one nut per day for the whole year.
What if the squirrel lives in Pennsylvania where there are only four winter months? Then the squirrel can cut its savings rate to 33 percent since it can save nuts for 8 out of the 12 months.
By working for two more months, the squirrel can eat more nuts (1 1/3 nuts per day!) and save less… Total nuts stored peaks after eight months. Then the squirrel sits back and eats his store of nuts during the remaining four months. In Pennsylvania, the squirrel has to work two months longer. But he will enjoy so many more nuts than his cousins in the cold north.
Take the squirrel example and apply it to retirement: You enjoy more when you save aggressively–and when you work longer.
You get to enjoy the riches when you’re not earning the nuts. So, let’s say you don’t put away a nut a day, you may not have enough to last the winter (i.e., retirement).
- The more you can sock away in various investments or retirement funds, and the less you throw away on unimportant “stuff,” the better you will live. Plus, you’ll be more secure as you get older.
The trouble is, as I’ll repeat, we simply do not save enough invest enough, or cut our expenses enough. The Social Security Administration recently published a grim statistic: 21 percent of retired couples and 43 percent of unmarried retirees rely on Social Security alone for 90 percent or more of their income.
In other words, they have no savings.
Step one is making sure we’re budgeting enough money to squirrel away. It can be hard to do when those impulse buys often seem more attractive than the far-away investments that will benefit us in the future. However, when you make that commitment, you can start thinking about what to do with that money—that is, where you’ll store your nuts.
In addition, we should define where investment begins—that is, when should you be thinking about doing beyond-the-basics type of money management?
Anybody can engage in investment activities, but my guideline is this: I’m writing this for the person who has a minimum of $75,000 to $100,000 to invest.
That means you have first set aside a liquid emergency fund to handle unexpected life occurrences, your personal debt is minimized (or has been converted to a tax-deductible form of credit), you have maxed out your retirement accounts at work, and your lifestyle budget is under control.
If that’s the case, then it’s time to look at the bigger picture.
Is the $75,000 to $100,000 an absolute minimum?
Of course not–but before you can start thinking about asset allocation and growth and investment portfolios, you need some sense of financial stability by having your other bases covered.
Now, on the larger asset side, if your potential investment amount is in the $500,000 range, then you’re really in a position where professional wealth advisors may be ideal to handle the complexities and opportunities that you have.
Because this area of wealth can be so complex, detailed, and as dry as a fossil, I’ll be covering the highlights—focused on what you want to know most.
Be forewarned: This won’t help you identify which stock is the hot stock. That kind of information changes too rapidly and, frankly, chasing hot stocks is an unwise course that most often ends in tears for the average investor. I hope to give you tools to help answer your investment questions and ultimately give you the discipline to make good choices.
With discipline and stick-to-it-iveness comes freedom, and that’s the ultimate goal anyway, right?
Why Does Investing Seem So Hard?
Investing can be hard for many reasons.
For one, it’s easy to brush off saving and investing for the future in exchange for living it up in the present. After all, that nice little ski vacation seems like a more fun way to spend your money than putting it safely away in some account you may not see for 20, 30, or 40 or more years.
It’s also hard because it’s something that few of us have experience with, due to schools offering little financial planning or savings and investment education.
When we see markets go up or down, we don’t know if it’s because of a bad choice that we made as investors or a function of the market. That’s not even counting one of the main reasons why we’re typically not so good at investing: We make decisions with our emotions. We get in and out of investments, or we make rash decisions, or we don’t dare to ride out the benefits of riskier investments—and that’s ultimately what gets us into trouble: investing with emotion, rather than with a sound strategy.
The first step in making smart decisions and coming up with a strategy for investments is addressing those weaknesses and making a commitment to save and invest smartly—not only for your future retirement but so you can get the most out of life.
I’m a little nervous (my Ulcer Index is really high) about investing in anything. Why can’t I just keep it in a safe and secure bank account?
Because doing so means you’re losing out—big time. It all comes down to saving consistently, investing strategically, and the magic of compound interest, which is the foundation for almost all financial-growth strategies. Without that compound interest, you lose money because of inflation—you erode the purchasing power of the money you already have. For example, let’s say you have $50,000 and put it in a savings account with a 1 percent interest rate. After 25 years, maybe you see a “big” gain in terms of absolute numbers, but if inflation is rising at 2 to 3 percent a year, your money is actually worth less in terms of what it will buy than when you started. After 25 years, you’ll have moved backward.
For those who don’t know, compound interest means that any money you invest grows and grows—not just because of the amount you have in your portfolio, but because your interest is earning interest, so you gain and gain and gain money every year at an increasing rate.
Let’s say you have $50,000 that you’re going to put in a savings account, and that account pays 1 percent interest every year.
- You add $5,000 a year to that account. At the end of 10 years, your balance will be about $108,000.
- Take that same $50,000 and $5,000 annual contributions.
- However, if we change the formula so that your earnings average 8 percent interest, that same investment means you’re now going to have about $186,000 at the end of the same 10 years in a qualified savings account.
That’s a huge difference, especially when you extrapolate the process out to 25 years. The difference between a 1 percent interest rate return and an 8 percent return is the difference between having about $207,000 at the end of 25 years and having $737,195 at the end. Quite a difference!
Here’s the truth: Safe and secure investments simply do not give you enough return on your principal, and you need investments with higher interest or growth rate return potential to allow compound interest to do the work and make you money. Plus, when you consider that, for today’s older generation, it’s much harder to prepare for retirement because the days when companies offered defined benefit pensions that would finance their retirement are long over.
That means individuals–even with corporate retirement help through matching programs, for instance–must take control of investing decisions and strategies that grow their savings in much more active ways than safe strategies, which end up costing you money in the long run.
Now, I can’t tell you to calm down, relax, and all of those “easy does it” type phrases. If you can’t stomach risk, it can be hard to handle.
You need the courage (and the long-term commitment) to handle the ups and downs that come with the market. The trick is that you have to stop worrying about the ebb and flow of the markets from day-to-day, month-to-month, even era to era.
If you’re in it for the long haul, you will always make more money with compound interest doing its job—even with riskier classes of investments. Financial author David Bach calls it being on “autopilot”—those automatic payments to long-term plans that grow and grow and grow and you don’t even notice them coming out of your expenses, but you do notice the big returns as they pile up over time.
The First Step of Investing
So you’re finally getting ready to get started. You have a fair amount of money sitting in a savings account ready to invest.
What’s the first step? Well, you hit the first thing right on the money: You had enough sense to ask the right question. Instead of letting your money waste away in that financial purgatory known as a savings account, you’re smart enough to now move forward with a strategy that will improve your financial picture—and future returns.
Make A Family Financial Agreement
One strategy is to create a family financial agreement. In this document, you will essentially take stock of your life and define what it is that you want out of it. You should list your financial goals and priorities.
Perhaps even more importantly, you should define roles:
- Who has responsibility for decisions and transactions?
- How are decisions made?
- Which ones are made together, and are any made separately?
This may seem sillier than a four-nosed clown, but the fact is that most financial conflict in families happens when people are unclear about expectations—and there is miscommunication. I thought you were going to put this in a college fund! I thought you wanted me to buy a new car!
It doesn’t matter what the responsibilities are (if one person wants to relinquish any contributions to the discussion, that’s fine if you both agree). That being said, it does matter that you outline those expectations—and agree to revisit them every year or so.
- When you treat investing like a true partnership and strategy within your family, your chance of success skyrockets.
The other part of this statement is that you outline what happens when the unexpected happens (and it will), be it with health issues or some other type of financial strain that you didn’t anticipate. Again, this is all done so that your family is literally on the same page when it comes to how to handle wealth not only in good times but also in bad (and uncertain) ones.
Have An Investment Policy Statement
You can consider the previous document one that is big picture oriented (the macro view). It’s all about your big thoughts and umbrella principles that guide not only your money decisions but also your other decisions when it comes to your personal and family life goals.
- The Investment Policy Statement gets a little more into the trenches of specific investment principles for the family.
Why is this important? Oftentimes, we’re raised with very different financial values and money principles. On one extreme, one person may have grown up with a spend-it-all mentality—as families treated themselves to anything and everything they wanted, no matter how much they leveraged their future against their immediate purchases. On the other extreme, one person may have grown up in a family where every penny was accounted for, saved, and barely saw the light of a day from a pocket because there was so much fear of losing it.
And in the big gray area in between are all kinds of families and all kinds of family financial values. So in any relationship, we come into it with very strong feelings about how we should save and spend money. In this statement, you will outline your investment philosophy (remember that ulcer index?). You want to outline your own tolerance for risk, whether there are certain areas you prefer to invest in, and other details about your investment strategy.
Max Out Your Retirement
Now that you are ready to start the investing process, the first area you have to consider is the retirement account options that you have through your work. Why is this first? This is your untouchable nest egg that will ensure that you and your family have sufficient funds to live comfortably when you stop working.
In addition, retirement accounts at work are often very attractive because they will provide tax-deferred or tax-free income and your employer will also make contributions, which is like getting free money. We all like free money, don’t we?
In a way, your retirement accounts are the easiest financial planning of all. You simply start the process, as early as possible when you enter the workforce. And then you don’t touch it. Don’t. Touch. It.
These accounts often give you some limited options about the type of assets you can invest in, I’m including this advice in the investment chapter to give you a broad idea about how to create a diversified portfolio. But bear in mind these are investments for the very long haul—you generally can’t touch them until you retire—so you want to take as much risk as you can stomach by putting most of your money in a fund that invests primarily in stocks.
The only stock I generally don’t recommend is your company’s own shares—that’s just betting too much on one company. Remember Enron? While it topped the list of Fortune magazine’s best companies for several years, it spectacularly went bust, taking the life savings of many thousands of employees with it.
Here’s the retirement formula to follow: You contribute the maximum possible money you’re allowed by law in whichever plan you’re eligible for (a 401(k), 403(b), an IRA); those funds being matched percentage-wise by employers, and you let the accounts grow and grow and grow throughout your life. When you’re ready to retire, that money will be there so you can live.
Ideally, those accounts (and your other investment accounts) will have grown so much that you’ll not only have plenty to live on, but you’ll also have plenty to pass on when you, well, do the same.
How to Invest Through Your Employer
When investing through your employer, the most common plan is a 401(k) in private-sector companies, or a 403(b) plan for public employees. You can contribute up to $18,500 each year, or $24,500 if you are 50 or older. Another advantage of an employer plan is that it results in immediate tax savings. You will have to pay Social Security and Medicare taxes, but the contributions are not subject to income tax.
Also, many employers will match contributions up to a certain level; for instance, the company might match 50 percent of contributions up to 6 percent of your income, which means that as long as you contribute 6 percent of income to the plan each year, you would be getting an additional 3 percent of income from the employer as a contribution.
The amount matched is not included in the contribution limits listed above. Some companies also combine their 401(k) plans with a profit-sharing plan, which allows employees to receive money each year based on the overall profitability of the company they work for, and to defer taxation on the additional income.
There also are several tax-advantaged options for retirement savings outside of work. You can contribute up to $5,500 to an IRA account ($6,500 if you’re 50 or older).
You can deduct these contributions from your income tax return each year, but only if your income is below a certain level. Another option is a Roth IRA, where the money you put in is taxed, but you will not have to pay taxes when you withdraw the money after age 59½.
The contribution limits for Roth IRAs are the same as those for traditional IRA accounts ($5,500 per year; $6,500 if you are 50 or older), and the ability to make contributions is subject to an income limit. One advantage to doing your own investing is that you have more flexibility to choose investments compared to many employer-sponsored plans.
If you’re self-employed, you have more retirement plan options than those who work for a large company. Perhaps the best option for self-employed individuals is a one-participant 401(k) plan, sometimes referred to as a solo 401(k). The great advantage of this type of plan is that you are allowed to contribute up to $18,500 ($24,500 if you are over 50) as an employee plus an employer contribution of 25 percent of your net income up to a total contribution of $55,000 in 2018.
Another plan for the self-employed is the Simplified Employee Pension, known as a SEP. You can make annual contributions of up to 25 percent of your net income up to a maximum of $55,000.
Now, of course, Social Security will provide some income in retirement (after all, that’s why “security” is in the name). But don’t be fooled into thinking that this will come close to being enough to live on in retirement. You can think of it as a supplement or a bonus to what your retirement accounts are generating, but it’s a mistake to think that this will be a major driver of income in your retirement years.
Start Your Investment Strategy With Liquid Capital
After you have sorted out your retirement plans at work, you need to think about having a fund for an emergency like a sudden medical expense.
Do what dehydrated athletes do: Start with something liquid.
That is, in any investment strategy, you have to take a portion of your total investment amount and put that in some kind of liquid account—where you can easily have access to the funds within 24 to 48 hours. This is a percentage of your main investment portfolio—say a 3 to 5 percent minimum of your total investment (or the equivalent of 6 to 9 months of your earned income).
We call this type of account a liquidity reserve account. It doesn’t make you much money, but it gives you immediate access via some kind of online checkbook or debit card that’s tied to it.
But what this does is create an additional checkpoint of confidence and comfort—knowing that when life throws you a curveball, you won’t swing and miss. In my mind, it is well worth having a portion of your investment portfolio available, even if it won’t net you a large return. Knowing that you have that comfort zone essentially allows you to be more diverse and take on additional risks in the rest of your portfolio.
What do you do after you have that liquid reserve? There’s no easy answer to this because everybody’s financial and lifestyle situations are like fingerprints—they’re all different. So I like to think of it this way.
- This investment portfolio is not your retirement account. That’s a long-term goal you’re handling with your 401(k)s and other similar programs.
When you think back to what the entire point of investment is—financial freedom now and in retirement—you understand that deferring your income to later years in formalized programs has to be the basis for any kind of investing that may follow. These other investment accounts will only add to your overall financial picture as you do retire—but more importantly, it gives you freedom and the flexibility to pursue your passions now. Right. Now.
This is the real reason why I’m so concerned about making sure you start with a solid foundation. life isn’t about how many dollars are in that portfolio. It’s about your experiences, your memories, your ability to help others, the wisdom you can share with your family, and your enjoyment of the people and places in this world.
Smart investment techniques allow you the freedom and flexibility to do all of those things. Best of all, you can do them all without even depleting your principal investment—by setting up investment accounts that deliver income above and beyond your professionally earned income.
So the first step is to adjust the mindset. This investment account is about living life—not about saving it until the end.
We always underestimate how much we’ll need as we get older. If you thought you could retire on a million bucks, that may not do it these days—not with longer lifespans, more expensive medical care, and the cost of inflation.
I can’t tell every one of you how much you’ll need because of all the variables (one reason why a personal wealth advisor is helpful is that he or she can do calculations that would give you a pretty good estimate), but I can tell you this: Whatever number you have in your head, you probably need to raise it higher and higher.
One key idea as you consider how to manage your nest egg is to maintain separate savings for the different goals you encounter in life. Each portion of your family portfolio should be developed with a different purpose and goal (that mind map can help you think of your goals in a visual kind of way).
The typical family may have six or ten different investment portfolios—be it with retirement accounts, children’s education accounts or personal investment accounts geared toward growth funds (which aren’t touched,) or income funds that allow you to derive some money every year.
I want to emphasize right at the start that investing is a long-term sport. Invest your money and forget it. This is known as buy-and-hold investing. If you want action, go to the movies or a basketball or hockey game, but don’t react to market ups and downs by jumping in and out of the market, which is called market timing.
A study by the Federal Reserve of St. Louis found that buy-and-hold investing outperformed strategies of chasing returns by up to 5 percent a year over the period from 1984 to 2012. Buy-and-hold investors earned up to 40 percent more in cumulative returns over seven years than market timers.
How to Pick the Right Types of Asset Classes For Investing
This brings us to the most important investing decision you will make: asset allocation, or how much goes into each type of investment.
What that means is that while it’s important to choose individual funds wisely, your portfolio’s overall earnings are more determined by the mix of investment types in your portfolio than the individual investments themselves. It’s common sense really: your grandmother probably told you it’s not wise to put all your eggs in one basket. I know mine did.
You probably know by now that there are several different asset classes you can invest in: equities (stocks or securities that show ownership of a company and are considered more volatile than other investments); bonds (investments in which you loan companies or governments money at a fixed interest rate); real estate, which can be a property or a real estate fund that invests in things like office buildings or malls; and what’s known as “liquid alternative investments,” the relatively new kid on the investment block, which includes funds that invest in such things as hedge funds and commodities like copper.
Why not stick with just one type of asset? As I have discussed earlier, markets never follow a smooth upward trajectory. Sometimes, for example, stocks will climb nicely by double digits, while bonds, like the famous tortoise in the Tortoise and the Hare story, earn a constant but dull rate of return.
Eventually, however, the stock market will decline—it always does—but those bonds will keep earning that boring but steady interest. When two asset classes, like stocks and bonds, act differently under changing market conditions, they are called uncorrelated.
One class tends to move up while the other chugs along or actually declines. By making sure your nest egg is divided into different asset classes, which we call a portfolio allocation strategy, you are much more likely to see consistent returns over time. The more uncorrelated asset classes that you have in your portfolio, the chances of your savings growing steadily are increased.
How can you decide how much of your savings to put into each asset class? Your asset allocation will depend a lot on how you answered that question. That’s because some asset classes are riskier than others.
There are two risk considerations that you need to contemplate when making your asset allocation. Your risk tolerance, as I described, is your emotional ability to weather the storms of market swings and sleep soundly. The other type is often called risk capacity: Your ability to take a loss without affecting your family’s lifestyle. Your risk capacity is determined by several factors, such as your present age and the age of your children.
If you are 30 years from retirement, you have more risk capacity than if you are retiring in two years’ time, when you’ll need to start withdrawing your savings. So every individual needs to adjust their asset allocation according to both their risk tolerance and risk capacity.
If I had to pick a generic allocation—one that works for many, many people—it would be this: 60 percent in equities, 35 percent in bonds (which includes the liquid portion of your investment portfolio) and real estate; and 5 percent in liquid alternatives.
This is the kind of portfolio that can get you through much of your working life until retirement nears when you want to start dialing up income and reducing investments in riskier assets. No one wants to start retirement with their portfolio crippled by a market downturn.
Once you have worked out your portfolio allocation, you need to think about what goes into each bucket. Just as owning some asset classes reduces risk, it’s been shown that returns are improved when you diversify your holdings into several investments in each class, such as equities. When you own several different stocks, the total risk to your savings is less than the risk of owning any single stock.
It’s simple really: One stock might be an agriculture company and another a bank. If there is a drought, that hurts the company that sells farm produce, but probably not the bank, which will keep on making money. So the portfolio continues to grow. This concept is commonly called diversification.
You could achieve diversification by buying a lot of individual stocks yourself, but there are transaction costs involved and it’s hard to keep track of which stocks seem promising. That’s why many experts recommend that novice investors use investments called mutual funds or exchange-traded funds, known popularly as ETFs. The share price of ETFs varies throughout the day as the components of their underlying portfolio fluctuate, while the price of mutual funds is reported at the end of each trading day.
Mutual funds come in two primary flavors: They either have an expert or team of experts who pick the stocks in the fund, which is known as a managed fund, or a computer buys all the stocks in a certain category, such as the S&P 500 stock index, which is called a passive fund because no one is making individual investment decisions. Most ETFs are passive.
Several veteran investors such as Warren Buffett, the CEO of Berkshire Hathaway, believe that passive index funds make the most sense for novice investors saving for things like retirement.
One reason is lower costs: mutual funds often charge fees of 1 percent or more of your invested assets annually, while index funds’ fees are much lower: an average of 0.1 percent. Fees impact your investment, so you must understand them.
Some great active managers have consistent track records (which is why you need professional help in choosing the right ones.) The higher fees charged by all actively managed mutual funds are supposed to compensate them for earning higher returns, but in reality, outperforming the market only happens in a minority of cases.
According to Morningstar, the fund ratings service, only one-fifth of large-cap stock mutual funds beat passive index funds over 10 years from 2005 to the end of 2014.
Don’t be swayed by ads that tout previous years’ stellar performance: That may have been a fluke that is not repeated.
I believe that the do-it-yourselfer should have a strongly diversified asset allocation with a commensurate amount of risk based on the investor’s time horizon. Here’s my ideal beginning breakdown for discussion (remember, the ideal is somewhat arbitrary because of all the variables):
- 40-50 percent in domestic equity mutual funds or ETFs. I seldom recommend individual stocks except for the most sophisticated investors working with a professional wealth advisor because of the much higher degree of attention required to monitor the market for potential downward surprises.
- 10-20 percent in low-cost international funds or ETFs, including a smaller component to emerging markets Despite additional risks and volatility, these investments in international markets can capture important gains not available elsewhere.
- 30 percent in fixed-income funds or ETFs (which are an alternative to owning individual bonds). You need to be aware that in a rising interest rate environment, there are additional risks in owning bond funds compared with individual bonds. While there is more diversification in a bond fund, you don’t own actual bonds but shares in the fund, so there is no chance to get back your entire principal when the bond matures, as you can with individual bonds. So choosing a well-managed bond fund becomes more important.
- 10 percent cash/ real estate/ liquid alternatives. When looking at index funds, it may seem like they are all alike because they invest in all the stocks in an index like the S&P or the Russell 2000. But that is not always the case. While index funds like the iShares S&P 500 Index Fund own all 500 companies in the index, the index is weighted by the dollar value of all the shares in the company. Companies with higher share prices get greater weight in the index. That means that emotions, like a fad for tech stocks or oil companies that are out of favor, can influence the performance of the index fund.
Joel Greenblatt, an adjunct professor at Columbia Business School, argues that investors are better off putting money in index funds that buy equal amounts of every share. Using the S&P 500 as an example, Greenblatt says index funds that bought equal amounts of stock earned 2 percent more than market cap-weighted index funds over 10 years.
You can also find index funds for a variety of asset classes and sub-classes, such as equities, global equities, and developing world equities; bonds, such as government bonds or corporate bonds.
Once you have made your initial portfolio allocation and invested your savings, you need to determine how you will continue to invest the money you are hopefully saving regularly. I recommend using an investment method called dollar-cost averaging.
How Often Should You Make Investments?
You may wonder what the best schedule to invest your hard-earned dollars is: Our recommended system is to start as early as possible in an automatic monthly dollar-cost averaging process.
What is dollar-cost averaging, and why is it crucial to the creation of wealth? Basically, it’s the technique in which you buy a fixed-dollar amount of a particular investment on a schedule, no matter what the share price, whether it’s up or down (you simply buy more shares when it’s low and fewer shares when it’s high).
Here’s how it works:
- After six months, at the current stock price of $10.50, the total investment would be worth $3,280, which is a 9.3 percent gain on the $3,000 that was invested. However, the stock has only gained 5 percent ($10.50 – $10/$10).
This is the beauty of dollar-cost averaging. By making regular purchases and buying stocks both when they are high as well as when they are low, in many cases, you can lower your overall cost of investment relative to buying at a given point in time.
Also, dollar-cost averaging takes much of the emotion out of investing, as it requires regular, systematic purchases. For those reasons, I highly recommend this as a strategy for adding to the investments you already have.
Can I beat the system? Short answer: NO.
If your goal is to get some kind of insider info that will make you millions overnight, you have about as much of a chance of doing that as you have a chance to successfully walk a tightrope over Niagara Falls.
- However, you can look for things that may not be the current investment fad.
For example, financial expert and Wharton professor Jeremy Siegel recommends investing in index funds that are globally diversified. That’s based on the belief that emerging markets tend to be undervalued, and you should have them a little more prominently in your own portfolios if you are aiming for maximum growth. Similarly, Siegel supports a concept called “fundamental indexing,” which emphasizes looking for stocks that are priced below their peer stocks and below the overall market, because of their growth potential.
How Often Should I Change Up My Asset Allocation?
Shopping for investments shouldn’t be like shopping for shoes. Try this one on, and this one too, how about that pretty little stock in a size 7? No matter what asset allocation you decide on, wait it out for at least a year. If you try to out-maneuver the market, you’ll never find that comfort zone where you’re letting your portfolio do the work for you. After an extended period (say, a year), it’s advisable to take a good look at your allocation and rebalance the portfolio into different asset classes. But be patient.
In terms of how you need to think of the approach and time frame of investing, it’s a novel, not a text message. I do suggest taking a look at your asset allocation every year to consider rebalancing your original percentage portfolio allocations.
That percentage shifts as your assets grow and fall, so rebalancing gets you back to your original allocation percentages and strategies. Doing so in a set period (say, one a year) has an advantage: It takes the emotion out of the process because you’re not trying to guess or outsmart the market. You just re-balance when it’s time.
That said, there will be some situations that come up that may force you to think about a totally different approach to how you invest. You may need more income, you may need more security, and you may need more access to immediate cash.
Therefore, you should do a risk assessment as described earlier, reevaluating and rebalancing if your life changes in any significant way.
These changes could include a change in wealth, a need for more liquid reserves (perhaps a health problem for a family member), reading that your industry is being exported to China, a change in your tax situation, changes in laws, or really any unforeseen circumstance that will change your life.
Do you see why those documents are necessary? It gives you a tangible place to go to think about your principles and adjust them as necessary.
Where does inflation fit into all of this? I’m glad you asked since that’s a place that a lot of people ignore when it comes to saving and investing—and then being able to spend that money. The fact is, most people underestimate (or fail to even think about) the role that inflation plays. That’s partly because inflation has been so low for a couple of decades that it really hasn’t affected most people. But inflation has started to creep up again, so it’s becoming a more important consideration.
Let’s say you save $1 million for your retirement and assume that because your portfolio makes 8 percent growth every year, you can earn an income in retirement of $80,000 a year.
That same $80,000 you draw every year isn’t worth $80,000 in old dollars; it decreases in value in terms of what it will buy every year. So there’s no accounting for future costs that will rise during retirement. This is one of the reasons why you need to have a balanced investment strategy.
If you invest only in stocks, it’s too risky and you could end up losing a lot of your principal in crucial years when you’re drawing income. And, if it’s too conservative–say, all in bonds–your portfolio won’t grow enough to draw income from your base and keep up with inflation. That’s why a balanced approach is best—it allows you to draw the benefits of both worlds (you see the rewards of substantial increases in your portfolio when stocks rise) but a safe place to land when the economy takes a turn.
In addition, that balance helps you account for any inflation that will happen during the time that you will be drawing from your retirement investments.
This is one of the reasons why I advocate only sticking to what I call the 4 percent rule: Drawing a maximum of 4 percent of your savings each year.
- Withdrawing only 4 percent of your investments is a traditional approach to ensure you have money that will last your lifetime.
Note: This 4 percent rule is an accepted formula based on historical trends and real rates of return, not just a random number that some investment advisors decided sounded good. To be conservative and ensure that your nest egg will be secure, cap your withdrawals at 3 percent per year.
How Do I Know I Need To Hire A Wealth Advisor?
Granted, I’m biased because this is my business. However, in almost any circumstance, I would advocate including a professional wealth advisor—so this person (and not you) can worry about the details, the fine print, the tax laws, the tax advantages, the asset protection, and be your voice of reason if and when things get emotional, volatile, or stressful, especially among family members.
- Once your portfolio starts to grow and grow, it’s always a good idea to include a pro.
Yes, there are fees involved, but the bottom line is that a good advisor will more than pay for himself or herself with the returns they can make that you otherwise wouldn’t.
Final Thoughts
While there are many independently-run strategies for managing your own investments, having a wealth advisor is a great tool. Sometimes, we need an expert. Sure, you might be able to fix your shower on your own–but the choice to hire a professional plumber gives you peace of mind that the work will be guaranteed. A professional does this for a living, and with your money and financial choices entrusted to someone who knows the ins and outs of the finance world, you can focus on what you do best.
However you slice it, investing is one way to grow your wealth and ensure you’ve got assets to support you for the long haul. Just like how a squirrel secures enough nuts to last the winter, it’s my goal to help you figure out what you need to save for the future of your dreams–and how we get you there.
Do you have enough nuts?