Feb 15, 2012

how to invest your money

I've helped enough people with this that I figure I'll just throw this out there.  As someone who has invested other people's money I get asked all the time, what should I do with my money?  There are really two questions within this question.
  1. What strategy should I use to invest my money?
  2. How do I implement that strategy?
Let's tackle the first one.  The answer is you should use low cost index funds to create a diversified portfolio of stocks allocated across a number of asset classes and then reallocate those funds when they get out of whack.

This is Passive Investing 101.  You are NOT going to pick stocks.  You are NOT going to hire other people to pick stocks for you (mutual funds). You are NOT going to change your exposure to an asset class because you think it is going up or down. You are NOT going to make 'active' bets on anything going up or down.

You ARE going to pick a portfolio of assets based on an allocation that makes sense for you (See Answer #2) and mechanically (as opposed to emotionally) keep your assets pinned to that allocation.  

Okay so why do I think you should invest passively.  Let's go through the reasons:
  1. Picking your own stocks is a loser's game.  Really?  You think you can pick stocks better than the rest of the market?  Even the people that do this full time can't beat the market.  Forecasting and prediction is hard.  Downright impossible.  And the further out your prediction, the greater the likelihood that the error increases.  There are hedge funds out there that purely invest in one small sub-sector of the market.  There is a hard drive hedge fund.  Are you going to pick hard drive stocks better than them?  Think of the resources they put to work on understanding these companies.  Even worse.  A lot of hedge funds cheat (insider trading).  You can't beat them.  You may do well due to luck.  But it won't be because you are good.
  2. Professional stock picking (mutual funds) is a loser's game.  Maybe not for the stock pickers but for you it is.  Most mutual funds don't beat the market.  And then on top of that you have to pay fees.  Significant fees that bite into your compounded returns.  Fees that are not based on how well they invest but based on how much money you gave them.  Does that sound right?  Well that's how it works.  You can't definitively beat the market with mutual funds.  You may do well due to luck.  But it won't be because you are good.
  3. Choosing professional stock pickers (mutual funds) is a loser's game.  This is the main reason to invest passively. Let's ignore point 2.  Let's assume a lot of funds beat the market.  How do you identify those winners?  I never see this question asked. But it is the most important reason for passive investing.  How do you pick winning mutual funds?  You are going to look at historical performance?  Really?  You think that matters?  There is no guarantee that the team that beat the market previously is the team you are investing in. I've seen the sausage making that goes into stock picking and it's ugly. People come and go in the asset management industry.  And if they are good they always go.  One of the supposedly best stock pickers was Bill Miller at Legg Mason. His Value Trust fund beat the S&P 500 15 years in a row.  Is he a good stock picker?  Everyone on Wall Street would have said yes.  And then 2007 happened.  And 2008.  In those 2 years he lost every single percentage point of outperformance he had previously gained in the last 15 years.  Let me rephrase that.  You could have bought his fund on 1/1/2007, LMVTX, at the price the fund was 15 years earlier (on 1/1/1992) and after two years you'd be behind the market in performance.  That's how bad 2007 and 2008 was.  He is, by definition, a below average stock picker.  He left the fund shortly thereafter.  How really do you expect to pick a fund that will beat the market over the next 15-30 years?  How?
Active investing is a fools game.  You may get lucky.  I won't deny that.  But at least know you are just gambling.

Why do you want to beat the market?
The last reason to passively invest is that passive investment gives you approximately market returns.  The whole reason to invest actively is to beat the market.  But why do you want to beat the market?  Because beating the market comes at the risk of not beating the market.  And the market over long periods of time gives you a good return for DOING NOTHING.  Where else do you get a deal like that?  My view is just get the market returns and be happy you live in a world where this is possible.  Don't fuck around with a free ride.  It costs you nothing because passive investing is ridiculously easy and low maintenance.  I don't have to look at the market and I only tend to my investments maybe once per year.  In return for that 'doing nothing' I should get a 5-6% post-tax post-inflation return over the next 15-30 years.

So if you buy into passive investing then how do you do it.  This is where for some reason the whole DIY ethic of the internet seems to fail.  No one really says, "Do this."  And people like when someone says "Do this."  So I'm going to tell you what to do.  I'll be prescriptive.  But at the end of the day you should feel free to modify as needed.  I built my prescription from what others have done but I modified it.  I'll allude to some of the ways to do that along the way.

The rules of Passive Investing
There are a few basic principles that a passive investing portfolio should have.
  1. Diversification - By diversifying we reduce risk without compromising much on return.  Or in other words we are removing some of the up and down volatility of our assets without paying too dearly with our return expectations.  Diversification is tricky, never perfect, and can/should involve a whole host of parameters.  On a simple level you want diversification across geographies, sectors, number of stocks, asset classes, and in my case, company styles.  The more the better.  Although you want something manageable at the end of the day.  To do this I use ETFs.  Passive funds that buy what's in an index and do it for very low cost.
  2. Allocation and reallocation - Allocation is just the activity of defining how much money goes into each investment vehicle you chose to invest in.  If you chose 4 investment vehicles, how do you deploy your pile of cash into those?  This is where typical advice breaks down because there isn't any really good scientific way to do this.  Some people argue there is but it's based off of faulty logic.  But the allocation part isn't terribly important as compared to the reallocation part.  As your investment vehicles go up and down your allocation of money gets out of whack.  Reallocating the holdings back to your original allocation is the most important activity you'll do and the one that gives you 90% of your returns.  And it's the one that NO ONE ever does. The reason it is important is because reallocation is just another way of saying, "Buy low, sell high".  Winners get sold and losers get bought.  We just don't do this naturally.  So making it prescriptive is the key to actually doing it.
Implementing the Rules.

1. Diversification

So to get diversification I've picked a number of low cost index funds or ETFs.  Index funds immediately diversify you on on a stock basis because each fund holds many of them.. And they are usually cheap.  By picking a number of different styles of index funds we diversify on those other parameters mentioned above - geography, company style, sectors, and asset classes.  Here they are:
    • US Large Cap Equities - SCHX (ER 0.08%)
    • US Large Cap Value Equities - VTV (ER 0.12%)
    • US Small Cap Equities - SCHA (ER 0.13%)
    • US Small Cap Value Equities - VBR (ER 0.23%)
    • International Large Cap Equities - SCHF (ER 0.13%)
    • International Large Cap Value Equities - EFV (ER 0.40%)
    • International Small Cap Equities - VSS (ER 0.33%)
    • International Small Cap Value Equities - DLS (ER 0.58%)
    • US REITs - VNQ (ER 0.12%)
    • International REITs - VNQI (ER 0.35%)
    • Emerging Markets - SCHE (ER 0.25%)
    • Short-term Bonds - SHY (ER 0.15%)
    • Intermediate-term Bonds - IEI (ER 0.15%)
    • Treasury Inflation Protected Bonds - TIP (ER 0.20%)
    • Commodities - IGE (0.48%)
    • Cash
This group of funds allows you to diversify across investment classes (cash, bonds, equities, REITs), geographies (US, international ex-US, emerging markets), company size (large and small cap), and company style (value and market average).  Value refers to whether the asset is cheap or not compared to other similar assets.  Traditionally value stocks, for example, outperform the market.  REITs (pronounced 'reets' are real estate investment trusts.  They are a little different from equities.

I've put the expense ratio (ER) of how much these funds take after each listing.  In general the ER for active funds is about 1%.  The weighted average ER of a portfolio of these funds is about 0.20%.  I just saved you 0.80% return per year right there.

You don't like cash? Or maybe you don't like REITs?  OR maybe commodities?  Too bad.  The idea here is not to invest in what you like.  It is to invest in a set of assets that are reasonably uncorrelated to other assets and yet earn returns over the long haul.  All of these do that.  The reason again why we are doing this is because when the market goes down 50%, for example, you have some cash tied up in assets that didn't go down 50% (like cash, debt or maybe commodities or something else).  You have assets that can be reallocated to the ones that went down.  Rationally we know buying low makes sense but when the market goes down 50% no one instinctively wants to do this.  Through this allocation you'll most likely have some assets that didn't go down and therefore some money to buy more of what did.

[Modification] You could add additional funds here.  And you could swap out funds for similar funds.  And you could get rid of some.  IGE is really an equity fund investing in companies reliant on commodity prices.  Maybe you want a true commodity ETF.  Also, the ERs change over time and if you can find a better one that tracks the index it follows then there's no reason not to switch it out.  And in some cases like in my TD Ameritrade account I get to trade some of these for free.

2a. Allocation
So here's another tricky part.  How to allocate your cash.  

First things first.  You should decide what you want to invest.  That means how much of your money is going to be invested for 10-20-30 years?  You need some rainy day funds.  That should NOT be in here.  You're making a big purchase next year.  Cash saved for that should NOT be in here.  All 401k/IRA stuff should be included.  

Second things second.  You should consider all the cash you're investing as a big fungible pile of cash.  We are going to allocate this big pile.  We are NOT going to allocate based on how your money sits in trading accounts.  Lump it all together and figure out the best way to allocate within your trading accounts.  For me I've rolled all 401ks into a single IRA account.  You may also have a current 401k plan that doesn't offer the investment vehicles listed above.  Try and pick something close.  Most 401ks offer a US large cap equities fund or a S&P500 type fund.  Use that type of fund to meet your allocation requirements.

Third things third.  All REIT funds go into a tax deferred account (IRA, 401k, etc.)  These funds dividend out most of their net income and you don't want to up your tax burden each year.  So stick those if possible into a tax deferred account.  If you can't it isn't the end of the world.

Fourth things fourth.  You may have stock in the company you work with.  You can't allocate that.  Personally I sell all stock in a company I work for as soon as I can.  Why double down on a single company.  You earn your income there and you are tying your investment performance on the same place.  If your company falters you risk losing those assets and your income.  It's the opposite of diversification.  Sell that shit pronto.

Fifth things fifth.  You have large gains and a large holding of some stock like Apple.  Sell it.  You got lucky.  Again you are doing the opposite of diversifying.  It won't end well.

With that out of the way here's my allocation:

For most people this should be a starting point.  I have about 74% in equities, 5% in REITs, 11% in bonds, 3% in commodities, and 7% in cash.  Do you feel comfortable with that?  If the global equity market goes down 50% can you stomach that loss assuming nothing else goes down?  Go ahead and calculate it.  Make sure your stomach doesn't churn.  Because if it does you are going to blink.  And if you blink you are going to start doing stupid things.  Like betting on the market or converting everything to cash.  Fix the risk of your allocation to something you can handle.

I think the litmus test is if your equity component goes down 50% while everything else is the same, can you deal with that?  Calculate what happens to your $1,000 or $10,000 or $1,000,000?  Can you handle it?  If not drop the equity percentages and up the cash and bond percentages.  Do it until you feel comfortable about that 50% drop.  Personally I think the equity component is a little high for most people.  But I'm not risk-averse in the context of a well laid out investment plan.  And while the market was going down in 2008 I was pumping cash in.  So I'm comfortable with my ability to not blink.  Make sure you are too.

Once again, deployment of this is straightforward.
  1. Group all your investable cash into one big pool and calculate how much of each security you need to buy at current prices.
  2. Buy the two REIT securities with your IRA or tax deferred accounts if possible.
  3. Buy everything else in your other accounts
  4. Done
  5. ???
  6. Profit
2b.  Reallocation
The final activity that needs to be done is reallocation.  Again there is some research on how to do this best but I think optimizing when the reallocation occurs may be minor event.  An easier way to do this is to simply reallocate once per year.  Pick a date and put it in your calendar.  Buy and sell what you need to get your allocation back to target.

[modification] A second thing to consider is to drop your equity holdings over time.  If you set yours to something like mine above.  You might consider dropping the total equity percentage (in my case 74%) 1% per year.  As you get older you'll want even less volatility because you'll be getting to an age when you will be pulling money out.

Finally, one way to avoid some of the tax burden at the end of each year is to try and save enough money such that you can rebalance not buy selling and buying securities but instead just buying securities to top off low percentages.  You'll still pay taxes (dividends, churn in the individual funds) but it avoids some of the taxes.

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