Making Investment Choices
Selecting your own mutual funds or exchange traded funds can be as simple or complex as you'd like it to be. As Chapter 2 showed, it can be a very simple matter of picking an all-in-one mutual fund, which is set up to provide you with income beginning in your retirement target date. If you'd like to have more say over the investments your money will go to, then you can do your own research to inform your decision.
The first concept you should become familiar with is the investment portfolio. Chapter 2 provided an example of portfolios that target date 2020, 2030, 2040, and Retirement Income funds might have. These portfolios include what the investment firms have determined is an optimal mix of investments during the years leading up to the target date, and eventually into retirement.
You can also create your own retirement portfolio using a mix of investments that you've determined is closer to meeting your objectives. There are many views regarding what constitutes the best portfolio, and the target date funds represent only a few of those. Retirement portfolios may be created out of an assortment of actively managed mutual funds or indexed-based exchange traded funds. These funds are composed of individual stocks and bonds, among many other alternatives beyond the scope of this book.
One other thing to remember is to always set up your fund or brokerage account so that all money earned is reinvested. This will substantially add to your investments over a long period of time, similar to how compounded interest can make credit card balances go up more quickly. Once you're retired, you can draw money out as needed, while keeping the reinvestment options turned on.
You may decide that you don't favor the very low risk and low return of US Treasury bonds as much as the target date funds do, and think taking on a little more risk is a good idea to achieve your objectives. There are many sources of information that could help you decide what your portfolio should be. Once you have a chance to look at several different options, their expected returns on investment, and potential downward swing, then you will have a better idea of what you like best. At the very least, you should be better prepared for a discussion with an investment professional.
Here are a few sites that provide portfolio models that you could use as a basis for select funds for your investments and rebalance your portfolio over time:
Vanguard Mutual Fund recommendation
Bogleheads' Asset Allocation info webpage
There are some very complex portfolio models involving a dozen or more investments. On the other hand, as the Boglehead website listed above will tell you, there are also very simple portfolio models composed of only three index-based funds. Anyone who's new to investing would probably be better off investing in a target date fund or a simple portfolio model such as those offered at the sites listed above.
For those needing a steady source of money, its possible to find undervalued stocks paying steady dividends of 5% or more, which can be important for those wanting to avoid the ups and downs of the stock market. Just keep in mind that dividend payments can also have their own ups and downs, and aren't guaranteed either. Another option is to invest in bond funds that pay regular interest. The main caveat with these types of investments is that the share prices of dividend paying stocks and bond mutual funds may drop as interest rates go up. Some bond funds, such as the Bulletshares funds, repay the principal amount invested in a future year, as well as regular interest payments. This assumes that none of the funds in the portfolio default.
If you have some extra time on your hands, then I suggest watching an Open Yale video that's accessible for free, and which was taught by a Nobel Prize winner in Economics, Dr. Robert Shiller. The other lectures of the course are also worth watching
Financial Markets (2011) Lecture 4 - Portfolio Diversification and Supporting Financial Institutions
Once you've decided upon a portfolio model, there are many websites that review mutual and exchange trade funds, provide ratings and a lot of data to consider. A few popular sites having this type of information are:
Some of the data on these sites is accessible for free, and other data is not. My personal view is that it's worth having the best information you can get while you're making investment decisions. Making poor investment decisions can cost you much more than subscription fees ever will. This may only require signing up for a month or two each year, rather than paying for an annual subscription. Sites such as Morningstar offer advice that is independent of the firms marketing investments, and delve deeply into the underlying management of mutual funds and companies they rate.
To get a more complete picture of a fund when considering whether to buy or sell funds, you can compare their ratings at different sites. Among the ratings to watch for on these sites are:
The performance of ETFs depends less on their management, and more on the performance of stock indices they represent. If you're wanting to invest in the top 500 companies in America, then you don't need an active manager to do that for you, and would be fine with an S&P 500 ETF. It's tough to “beat the market” (or the stock index) when the companies you invest in have lots of professionals watching them and analyzing everything they do. On the other hand, if you'd like to diversify to small company stocks in developing nations, then knowing you have well qualified active fund managers digging into their details is probably good idea. This doesn't eliminate all risk by any means, but neither does bucking your seatbelt and eating healthy every day. Some actively managed funds regularly beat the stock indices that they track. Many of the online research sites show how funds perform relative to the stock index they're tracking.
For the most part, the jury still remains out on whether to buy mutual funds or exchange traded funds, and each option has advocates and detractors. My view is that there's no “one-size fits all” answer to this question. If you're investing for retirement, then it's likely you will be making many recurring investments and withdrawals. Having a mutual fund can help you avoid transaction costs from buying and selling, assuming it's a no-load fund, however you may pay more in annual fees than with an exchange traded fund. Some fund companies, such as Vanguard, keep their actively managed mutual fund management fees fairly low.
Some online brokerages, such as Fidelity, Schwab and Vanguard, do not charge transaction fees for purchasing or selling ETF's in their fund families, or for certain others they're affiliated with. This type of option makes the ownership of many index-based ETF's very inexpensive. Some actively managed funds regularly outperform those ETF's by much more than the additional annual management fee those mutual funds charge. ETF advocates claim often this is not the norm, however it occurs frequently enough that you should pay close attention to fund performance data, and how each investment option compares to other similar investments. You should always consider the relative fees in comparison with the fund's performance and the performance of the index it tracks. Regardless of the type of fund you invest in, always read the fund prospectus to understand it before buying any shares. Also review the reports these funds produce each year, which provide updates on how they're doing and discuss major changes.
The Securities and Exchange Commission provides the following information:
Beginners' Guide to Asset Allocation, Diversification, and Rebalancing
Even if you are new to investing, you may already know some of the most fundamental principles of sound investing. How did you learn them? Through ordinary, real-life experiences that have nothing to do with the stock market.
For example, have you ever noticed that street vendors often sell seemingly unrelated products – such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never – and that's the point. Street vendors know that when it's raining, it's easier to sell umbrellas but harder to sell sunglasses. And when it's sunny, the reverse is true. By selling both items- in other words, by diversifying the product line - the vendor can reduce the risk of losing money on any given day. If that makes sense, you've got a great start on understanding asset allocation and diversification. This publication will cover those topics more fully and will also discuss the importance of rebalancing from time to time. Let's begin by looking at asset allocation.
Asset Allocation 101
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
Risk versus Reward
When it comes to investing, risk and reward are inextricably entwined. You've probably heard the phrase "no pain, no gain" - those words come close to summing up the relationship between risk and reward. Don't let anyone tell you otherwise: All investments involve some degree of risk. If you intend to purchases securities – such as stocks, bonds, or mutual funds - it's important that you understand before you invest that you could lose some or all of your money. The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents. On the other hand, investing solely in cash investments may be appropriate for short-term financial goals.
Investment Choices
You should know that a vast array of investment products exists – including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds, money market funds, and U.S. Treasury securities. For many financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy. Let's take a closer look at the characteristics of the three major asset categories.
Stocks, bonds, and cash are the most common asset categories. These are the asset categories you would likely choose from when investing in a retirement savings program or a college savings plan. But other asset categories – including real estate, precious metals and other commodities, and private equity - also exist, and some investors may include these asset categories within a portfolio. Investments in these asset categories typically have category-specific risks. Before you make any investment, you should understand the risks of the investment and make sure the risks are appropriate for you.
Why Asset Allocation Is So Important
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.
The Magic of Diversification.
The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain. In addition, asset allocation is important because it has major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family's summer vacation.
How to Get Started
Determining the appropriate asset allocation model for a financial goal is a complicated task. Basically, you're trying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can live with. As you get closer to meeting your goal, you'll need to be able to adjust the mix of assets.
If you understand your time horizon and risk tolerance – and have some investing experience – you may feel comfortable creating your own asset allocation model. "How to" books on investing often discuss general "rules of thumb," and various online resources can help you with your decision.
In the end, you'll be making a very personal choice. There is no single asset allocation model that is right for every financial goal. You'll need to use the one that is right for you.
Some financial experts believe that determining your asset allocation is the most important decision that you'll make with respect to your investments – that it's even more important than the individual investments you buy. With that in mind, you may want to consider asking a financial professional to help you determine your initial asset allocation and suggest adjustments for the future. But before you hire anyone to help you with these enormously important decisions, be sure to do a thorough check of his or her credentials and disciplinary history.
The Connection Between Asset Allocation and Diversification
Diversification is a strategy that can be neatly summed up by the timeless adage "Don't put all your eggs in one basket." The strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.
Many investors use asset allocation as a way to diversify their investments among asset categories. But other investors deliberately do not. For example, investing entirely in stock, in the case of a twenty-five year-old investing for retirement, or investing entirely in cash equivalents, in the case of a family saving for the down payment on a house, might be reasonable asset allocation strategies under certain circumstances. But neither strategy attempts to reduce risk by holding different types of asset categories. So choosing an asset allocation model won't necessarily diversify your portfolio. Whether your portfolio is diversified will depend on how you spread the money in your portfolio among different types of investments.
Diversification 101
A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. So in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, you'll also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions.
One of way of diversifying your investments within an asset category is to identify and invest in a wide range of companies and industry sectors. But the stock portion of your investment portfolio won't be diversified, for example, if you only invest in only four or five individual stocks. You'll need at least a dozen carefully selected individual stocks to be truly diversified.
Because achieving diversification can be so challenging, some investors may find it easier to diversify within each asset category through the ownership of mutual funds rather than through individual investments from each asset category. A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, and other financial instruments. Mutual funds make it easy for investors to own a small portion of many investments. A total stock market index fund, for example, owns stock in thousands of companies. That's a lot of diversification for one investment!
Be aware, however, that a mutual fund investment doesn't necessarily provide instant diversification, especially if the fund focuses on only one particular industry sector. If you invest in narrowly focused mutual funds, you may need to invest in more than one mutual fund to get the diversification you seek. Within asset categories, that may mean considering, for instance, large company stock funds as well as some small company and international stock funds. Between asset categories, that may mean considering stock funds, bond funds, and money market funds. Of course, as you add more investments to your portfolio, you'll likely pay additional fees and expenses, which will, in turn, lower your investment returns. So you'll need to consider these costs when deciding the best way to diversify your portfolio.
Changing Your Asset Allocation
The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you'll likely need to change your asset allocation. For example, most people investing for retirement hold less stock and more bonds and cash equivalents as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.
But savvy investors typically do not change their asset allocation based on the relative performance of asset categories – for example, increasing the proportion of stocks in one's portfolio when the stock market is hot. Instead, that's when they "rebalance" their portfolios.
Rebalancing 101
Rebalancing is bringing your portfolio back to your original asset allocation mix. This is necessary because over time some of your investments may become out of alignment with your investment goals. You'll find that some of your investments will grow faster than others. By rebalancing, you'll ensure that your portfolio does not overemphasize one or more asset categories, and you'll return your portfolio to a comfortable level of risk.
For example, let's say you determined that stock investments should represent 60% of your portfolio. But after a recent stock market increase, stock investments represent 80% of your portfolio. You'll need to either sell some of your stock investments or purchase investments from an under-weighted asset category in order to reestablish your original asset allocation mix.
When you rebalance, you'll also need to review the investments within each asset allocation category. If any of these investments are out of alignment with your investment goals, you'll need to make changes to bring them back to their original allocation within the asset category.
There are basically three different ways you can rebalance your portfolio:
If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance.
Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to use will trigger transaction fees or tax consequences. Your financial professional or tax adviser can help you identify ways that you can minimize these potential costs.
Stick with Your Plan: Buy Low, Sell High – Shifting money away from an asset category when it is doing well in favor an asset category that is doing poorly may not be easy, but it can be a wise move. By cutting back on the current "winners" and adding more of the current so-called "losers," rebalancing forces you to buy low and sell high.
When to Consider Rebalancing
You can rebalance your portfolio based either on the calendar or on your investments. Many financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing.
Others recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you've identified in advance. The advantage of this method is that your investments tell you when to rebalance. In either case, rebalancing tends to work best when done on a relatively infrequent basis.
You can find out more about your risk tolerance by completing free online questionnaires available on numerous websites maintained by investment publications, mutual fund companies, and other financial professionals. Some of the websites will even estimate asset allocations based on responses to the questionnaires. While the suggested asset allocations may be a useful starting point for determining an appropriate allocation for a particular goal, investors should keep in mind that the results may be biased towards financial products or services sold by companies or individuals maintaining the websites.
Once you've started investing, you'll typically have access to online resources that can help you manage your portfolio. The websites of many mutual fund companies, for example, give customers the ability to run a "portfolio analysis" of their investments. The results of a portfolio analysis can help you analyze your asset allocation, determine whether your investments are diversified, and decide whether you need to rebalance your portfolio.