How should you pick investments and how much risk should you
take? The question came in an email from my son, who is in his senior
year enroute to an economics degree. Seems a bit presumptious for a
plugger like myself to answer a question from someone studying economics,
but perhaps experience counts for something. The question refers
specifically to picking stocks and bonds.
First, let me say I practically never pick stocks and bonds. I used to
do that 30 years ago, and I enjoyed the challenge. I loved the thrill
of occasionally beating the averages, but I also got experience with
underperfoming the market, and over several years I noticed that, on
average, I underperformed the market by about 2 percent. I listened to
others talk about their big winners, but when I dug a little deeper I found
losers that largely offset the gains. I read the bold advertising of
professionals who had beat the average over this and that period, but I
noted the research that says 80% of both professional managers and
individuals underperform the averages in the long term. Of course, costs
were higher back then, with only a choice of full service brokerages, but
the statistics still paint much the same picture. I soon realized that
picking stocks, even with a professional manager/advisor was a bit like
going to Vegas. You might hit big, but over the long run you almo!
st certainly will lose a percentage of what you play, at least on a
relative basis versus the averages.
Fortunately, the market is not like Vegas in its average returns. It
almost always wins over the long term. So, if you can match or slightly
beat the averages over the long term you can accomplish your goals,
rather than gamble with them. And there is an almost surefire way to do
that with index funds. And, the really good news is that with index funds
you can largely negate one of the cardinal rules of investing…that a
probability of high returns can only be accomplished with higher risk.
I’ll talk more about that later.
So, let’s talk about index funds. These are funds designed to replicate
the performance of their target index. Costs are one of the few things
you can control in investing, and no-load index funds have extremely
low costs, particularly those from Fidelity and Vanguard.
How do you pick the index funds? First, make sure you are picking from
no-load, low cost index funds. The best cost nothing to buy and have an
expense ratio on the order of 0.1% per year. Then decide on your
allocation. This will depend on your risk tolerance, which I will discuss
later, but I believe everyone should have all of the following types of
funds:
1. International
2. Small Cap Domestic
3. Mid Cap Domestic
4. Large Cap Domestic
5. Long Term Bonds
6. Short Term Bonds, money market or cash
These can be sliced and diced more finely with value vs growth,
sectors, etc., but generally I’ve found the above will give sufficient
diversification. Then simply pick the index funds representing each class from
your fund family and invest the proper percent in each. The percentage
allocated to each class is known as your allocation.
What should your allocation be? This is where risk enters the picture.
I have listed the above classes with the generally accepted highest
risk investments at the top and the lowest at the bottom. Just allocate
according to your risk tolerance.
So, how do you determine your risk tolerance? To some extent this is a
personal decision. It is easy to think you have a high risk tolerance
when you are not under pressure, but how will you react if things start
going bad. Often, folks see their risk tolerance quite differently when
they are under pressure and begin making changes in the time of stress.
This approach will yield disastrous results. Make sure you are
comfortable with your level of risk and stick with the allocation based on
that.
Even so, there are some guidelines. Generally the risk you take should
be proportional to your time horizon. If you’ll need the money in a
year or two, you should keep it in low risk investments. If you won’t need
it for 30 years or more you should take more risk. Almost everyone
should have 3-6 months living expenses in short term investments, since the
emergency could well arrive tomorrow. And a typical rule is that the
percent invested in stocks for retirement purposes should be equal to 100
less your age, although with the system discussed below,
I feel comfortable with a larger proportion in stocks.
The discussion could go on and on, but with these guidelines, you
should be able to set an allocation with which you are comfortable and find
the funds to satisfy that allocation, but before you do, let me discuss
the relationship of diversification, dollar cost averaging and
rebalancing on risk and return.
With a well diversified portfolio, risks are greatly reduced because
the up and down cycles of each individual class move largely
independently of each other. That means that the risk of the portfolio is much less
that the risk of each individual class. Dollar cost averaging and
frequent rebalancing also reduce the risk. And the beauty of it is that
these measures do not reduce the return as might normally be expected by
the risk/return relationship. In fact, my experience indicates that the
dollar cost averaging and rebalancing increase returns over the average
performance of the funds allocated by as much as 1-2% per year. This
may not sound like much, but over 30-40 years this can result in a nest
egg 50-100% larger than average, due to the power of compounding.
So there you have it. Assess your risk tolerance. Determine your
allocation. Buy index funds regularly in accordance with your allocation to
dollar cost average. Rebalance regularly. Enjoy superior returns with
less risk. Throw in a little real estate (your home) for additional
diversification and you are on your way to financial independence.
If you really enjoy the thrill of investing directly in stocks, set
aside a small amount for that purpose, but invest for your future with the
discipline outlined above.