investing: the name of the game

When I first meet with clients, they often have very particular views on investing, generally coming from what they’ve heard all their lives. “It’s all about beating the market, maximizing the return on investment.” “Buy what you know.” “I need to make my portfolio more conservative as I retire.” “We need to invest in gold because of the administration’s fiscal policy.” And you’ve got shows like Mad Money which seem to promise that you can always make money, if you just buy and sell the right stock at the right time. I’m constantly reminded of how much misinformation (or partially-true or out-of-context information) is out there, and the Internet hasn’t really helped that much. Hence, this blog.

So let me address that first one: “beating the market”. I hear that all the time, and I wonder if people even know what that means. What market? The S&P500 — 500 of the largest US companies? Or the Russell 1000? Or the Russell 2000? Or the MSCI EAFE index, an index of companies Europe, Australia, and the Far East? Or all of those? What about the bond market?

Point being: sure, I could beat the S&P500 over the long term, simply by investing in a riskier-but-more-rewarding market. But that would involve taking on more risk. Is that what you want? Or are you saying that you want the most reward for a given amount of risk, or vice-versa? Now you’re starting to ask the right questions — and they’re questions that will vary from person to person!

And that is what investing is “all about”: quite simply, determining the return you desire and/or the risk you require, and then determining what combination of investments will give you the best combination of the two. That’s it.

And before you can do that, you need to figure out what your investments are for. It’s vitally important and many investors don’t do it! Are your investments for retirement? A legacy? Saving for a house? An emergency fund? This will have a massive influence on how you invest! If you might need the money next month, why on earth would you invest it in the emerging stock market, which could get cut in half next week? And if you’ll need the money thirty years from now, why on earth would you invest in short-term bonds, where inflation would eat your returns alive?

Let me be clear: I don’t care how smart your broker is. If your investments are risky — stocks, junk bonds, etc. — then your investments are going to occasionally take a dip, along with the market. That’s just how it is. A really smart broker may be able to swing the needle a little bit, but they’re never going to time the market perfectly so as to always make money every day.

So: forget what Jim Cramer says. Don’t worry about which stocks to buy or sell NOW. Think about what your goals are, put together a portfolio (or portfolios) that make sense for those goals, and rest easy. And for God’s sake, turn off CNBC.

What do I filter out, and what do I tune in to?

People who’ve worked with me know one of my favorite sayings: “benign neglect is one of the best investment management practices you can engage in.” (I wish I could say I came up with it; rather, it was Warren Buffett, though his language was a little stronger.) The financial news is constantly looking for something to panic over; a few weeks ago, it was China, and before that it was Greece. The Wall Street Journal says it better than I can; go ahead and read, I can wait.

At the end of the day, 99% of financial news can be boiled down to this: “the markets go up, and the markets go down”. But we already knew that, didn’t we? Especially my clients, who through their weekly statements have become accustomed to the short-term ups and downs of the stock market.

But if we’re supposed to ignore 99% of financial news, that doesn’t mean that we should just stick our heads in the sand, does it? No, of course not. The question to ask is: how does this affect me in the long term? Not the gobal economy, not in the short term: me, in the long term. So if someone talks about oil prices — which are constantly bouncing around — then you can safely ignore it and change the channel (or turn to the sports section); but if you come across an article where an economist talks about a change in long-term projections, then your ears might start to perk up a bit.

Of course, while such articles do indeed discuss the long term, they don’t talk about *you*, in particular. For that, we need a metric for how on-track you are to meet your goals. And no, I don’t mean just your current portfolio balance! As we said earlier, the market is constantly going up and down, and investing isn’t a game where you’re just trying to get more dollars; rather, it’s all about balancing risks against reward. Is your portfolio too heavily weighted towards stock, such that a sudden market correction at the wrong time might throw a wrench in the works? Or is your portfolio weighted too heavily towards bonds, so that it’s not growing fast enough to meet your needs?

My clients are familiar with the “success rate” metric that I use for exactly this purpose: a percent value that represents the likelihood, after all the ups and downs of the market, of meeting your goals. This kind of number is the Gold Standard, the ultimate arbiter of whether you should take action based on the financial news: if the market takes a dip, but your success rate is still in your target range, then you can sleep peacefully. If your success rate starts to drop below target, then you can still sleep peacefully, but now you have work to do: perhaps changing your allocation, revising your goals, increasing your savings rate, or delaying retirement. Regardless, you have an indicator that tells you exactly how much action to take –no more, and no less.

Sounds pretty cool, doesn’t it? Instead of some vague feeling of dread that you might not be able to retire, you can get a concrete indicator that tells you exactly when it’s time to take action. If this is something that sounds interesting to you, I’d be happy to put together a financial projection for you, gratis. (Even if you already have a financial advisor, it’s worth getting a second opinion — or a first opinion, if they don’t offer this kind of metric!) Just click the link, and I’ll be in touch!

roll your own target date fund, part 4: the funds

Alright, now it’s time to get down to the nitty gritty. You’ve decided on an allocation and you’ve decided on a location. Now for the big question: what funds do you actually buy? As it turns out, this part is actually simpler than you might think. There are two main rules:

#1: Follow your allocation. This means avoiding funds that are mixes of different asset classes, which includes most actively-managed funds, since they almost always contain some amount of cash.

#2: Find the lowest expense ratio possible. Forget Morningstar ratings; within a given asset class, expense ratio is the best predictor of fund performance. Now, this is simultaneously intuitive and counter-intuitive — one would expect a cheaper investment to be a better bargain, but at the same time, one would expect someone who charges more to give you more for your money. That’s certainly what expensive funds would like you to believe, but the research — including Morningstar’s own! — doesn’t bear that out.

With those two rules in mind, let’s take a look at 401(k)’s and IRA’s.


With 401(k)’s (and 529’s), rule #1 is generally enough to suffice: you rarely have more than one fund per asset class, which makes the choice easy. However, sometimes there’s no direct match, in which case you just do the best you can. Here’s a list of funds you might swap out a given asset class for, in order of preference:

  • Large Cap -> Total US Stock -> Total World Stock
  • Large Cap Value -> Large Cap -> Total US Stock -> Total World Stock
  • Small Cap -> Total US Stock -> Large Cap Value -> Large Cap -> Total World Stock
  • Small Cap Value -> Small Cap -> Total US Stock Index -> Large Cap Value -> Large Cap -> Total World Stock
  • REIT -> Large Cap -> Total US Stock -> Total World Stock
  • International Developed -> Total Ex-US Stock -> International Large Cap -> Total World Stock
  • International Small-Cap -> International Developed -> Total Ex-US Stock -> International Large Cap -> Total World Stock
  • International Emerging Markets -> International Small-Cap -> International Developed -> Total Ex-US Stock -> International Large Cap -> Total World Stock
  • Intermediate-Term Bond -> Total US Bond
  • Short-Term Bond -> Intermediate-Term Bond -> Total US Bond
  • Inflation-protected Bond -> Short-Term Bond -> Intermediate-Term Bond -> Total US Bond


Now, with an IRA, your choices are much, much broader, bordering on overwhelming. However, given that the ideal per the above rules is (a) a “pure” mutual fund, and (b) an inexpensive one, the choice becomes clear: Vanguard index funds. You can easily find an index fund that matches any of the given categories above, and it is virtually guaranteed to have the lowest expense ratio in its class. Also, you can avoid brokerage fees by opening your IRA with Vanguard itself. The only caveat is that Vanguard funds often have a minimum ($3,000 is the most common). If you have less than this, you can substitute funds as per above; for example, you could combine all of your stocks into Total World Stock and all your bonds into Total US Bond.

(Sounds like an advertisement, I know. But Vanguard doesn’t know me from Adam. I just like their funds.)

That’s it — you’re done! Once you’ve come up with your allocation, all you have to do is rebalance periodically to stick with your target (and update your target as circumstances change). More on that in a future post.

In the meantime, if there’s a related topic you’d like me to go over in detail, let me know in the comments!

roll your own target date fund, part 3: location, location, location

forsalehouseWelcome to part three of my series on rolling your own target date fund — taking charge of your own investments so as not to get blindsided, but without spending every waking moment reading the Wall Street Journal. Last week was all about the biggest factor in determining how volatile your portfolio is going to be: your asset allocation. This week, we talk about where best to place those assets. Yep, it’s all going to be about taxes and fees, fees and taxes. Since the vast majority of your investing is going to be for retirement, today I’m just going to talk about retirement vehicles; if you’d like to know about college savings, you might want to check this out.

Ready? Let’s go.

401(k)’s: For lots of you, this is where nearly all of your investments will be located. Many companies offer a 401(k) match (in lieu of a pension plan), which can make investing in a 401(k) a tasty treat. However, once that match has been met, a 401(k) becomes much less appetizing. For one thing, there are generally only a small handful of choices to invest in; this wouldn’t be terrible, were it not for the other thing, which is that either (a) most of the choices are expensive, or (b) there is a fee tacked on top of the funds’ normal expense ratios, or (c) both. 401(k) administrators have to make money somehow! So generally, once you’ve hit the match on your 401(k), it’s time to move on to a better home, like…

IRA’s: An Independent Retirement Account is generally a better alternative for retirement investing than a 401(k): your options are better, especially if your IRA is with Vanguard, where you have access to some extremely nice, low-cost, no-load funds (more on that next week). And there are no fees. However, there’s a couple caveats: for one, as of this writing you can only contribute $5,500 annually to your IRA ($6,500 if you’re 50 or older), while you can contribute $17,500 to your 401(k). (And yes, you can do both!) For another, IRA’s are subject to an income limit, so some people can’t contribute at all*.

Roth v. Traditional: Now, 401(k)’s and IRA’s come in two different flavors: Traditional and Roth. The main difference lies in how they’re taxed: Traditional IRA’s and 401(k)’s are tax-deferred, which means that you don’t have to pay taxes on the money you contribute, but you do have to pay normal income taxes on money that’s withdrawn in retirement. Meanwhile, Roth 401(k)’s and IRA’s grow tax-freewhich means that while you are taxed as normal on your contributions, your withdrawals are completely tax-free. A couple related wrinkles to also consider:

  • For any given amount of money contributed to a retirement account, you’ll get more out in retirement if you contribute to a Roth rather than a Traditional. The logic is simple: $5,000 in a Traditional will be taxed when you pull it out, while $5,000 in a Roth won’t be.**
  • Contributions to a Roth IRA (not 401(k)) may be withdrawn at any time, tax-free. Note that this does not include capital gains, and that this is a withdrawal, not a loan, so you can’t just put the money back when you’re done if you’ve already contributed the maximum allowed amount for the year.

So…what to do? Everyone’s situation is unique, but a good strategy for most people when allocating your contributions is to contribute to your 401(k) up to your company match (the Roth option, if your company offers it), then max out your Roth IRA, then max out your 401(k). 

Got it? Great! Next week, we’ll get down to brass tacks: exactly what funds to buy to implement that asset allocation you crafted from last time!


* You’re right, that’s not entirely true: there is a sneaky backdoor, where you can contribute to a nondeductible IRA at any income level, and roll that over to a Roth IRA. Good call, have a lollipop.
** The same smart kids who got a lollipop will note that because you’re not taxed on contributions to a Traditional 401(k)/IRA, you could in theory afford to contribute more to it. This is true…until you reach the max, which is the same dollar amount for a Roth as for a Traditional. So: the Roth wins. Nyaah nyaah.

roll your own target date fund, part 2: allocations

Pie chart made with 100% real pie. Photo by echang via stock.xchng.

Hopefully, last week convinced you that while a target date fund is a good place to start, ultimately it’s up to you to make the right decisions for your portfolio. Of course, you already know that the most important investing rules are 1) save earlier, 2) save more, and 3) be tax-efficient, but asset allocation is right up there; it can make the difference between a smooth transition to retirement and losing half your portfolio the year before! So: following are some simple guidelines for constructing your asset allocation. I could write a book on this — and many people have — but I’m going to fly through a top-level summary here, so that you have just enough information to construct a decent allocation.

Step 1: Cash. Any money you’re going to need in the next two years should be in cash or cash-equivalents; generally, this means a money-market or stable value fund. Why? Because even a short-term bond fund isn’t guaranteed to maintain its value, and in fact, it was a full year before many such funds recouped their losses from their peak in 2007.

Step 2: Stock/bond allocation. The rest of your money should be broadly divided between stocks and bonds. Stocks are riskier but have a higher expected return; bonds are more stable, but have a lower expected return. Your stock/bond allocation is absolutely critical; much of the rest is gravy, if you’re making halfway decent decisions. An allocation to all stocks means the risk of losing half your portfolio in a given year; an allocation to all bonds means having inflation devour your returns. Let’s walk through one way to calculate your stock/bond split:

Step 2a: How much can you lose, without losing sleep? This is probably the hardest question to answer honestly. A lot of folks thought their appetite for risk was greater than it actually was…and then 2007 happened, and they panicked so badly that they sold everything and went to cash. This is precisely what you want to avoid; you want to balance your maximum equity allocation with your maximum tolerable loss. You can thank Larry Swedroe and William Bernstein for the following table:

 Maximum Tolerable Loss  Maximum Equity Allocation
5% 20%
 10% 30%
 15% 40%
 20% 50%
 25% 60%
 30% 70%
 35% 80%
 40% 90%
 50% 100%
Step 2b: When will you need the money? Your appetite for risk may be sky-high, but your portfolio’s might not be, depending on how far out your goals are. Here’s another table, again courtesy of Swedroe and Bernstein.
 Time Horizon (years) Maximum Equity Allocation 
 0-2 cash
 3 10%
 4 20%
 5 30%
 6 40%
 7 50%
 8 60%
 9 70%
 10-14 80%
 15-19 90%
 20+ 100%

Step 2c: Use 2a and 2b to determine your equity allocation. In other words, choose the lesser of the two; this represents the most risk you should take with your portfolio, both from your personal point of view and your portfolio’s. 

Step 3: Divide your equity portfolio into international and domestic components. Basic allocation: 30% international, 70% domestic. The US is about 50% of the global market, but there is some uncompensated risk to international investments (namely currency fluctuations and event risks caused by restrictions on foreign investors, if you’re interested).

Step 4: Divide your domestic equity portfolio into sub-categories. Basic allocation: 10% of your equities be in real estate, because it often (not always!) tends to move in an uncorrelated fashion from other equities, with the rest divided equally between large-cap equities, large-cap value equities, small-cap equities, and small-cap value equities. (I recommend the tip towards value because growth stocks tend to be less “efficient”, i.e. less stability for their lack of return compared to value.)

Step 5: Divide your international equity portfolio into sub-categories. Basic allocation: equal portions developed, international small-cap, and emerging markets. (If that sounds like a high allocation to emerging markets, remember: this is only 30% of your equity portfolio.) If you don’t have access to an international small-cap fund, feel free to put that part in developed, as well.

Step 6: Divide your fixed income portfolio into sub-categories. Basic allocation: equal portions short-term bonds, intermediate-term bonds, and inflation-protected bonds. I don’t recommend long-term bonds because they’re generally quite volatile for the modest increase in returns they give you, and I don’t recommend junk bonds because they put instability into the stable part of your portfolio.

There you have it — your own personal asset allocation. Note that beyond the cash/stock/bond split, I pretty much dictated the sub-allocations; this was done for simplicity’s sake. If I ever write that book, I’ll probably have a lot more to say on the matter; for now, however, this will get you most of where you want to go.

An asset allocation is really an abstract concept, however; next week, we’ll talk about the actual investments you’ll use to implement your allocation!

roll your own target date fund, part 1: introductions

If there’s any place where the investment world falls into the “one-size-fits-all” trap, it’s in target date funds. Don’t get me wrong — they’re a good place to start — but the chances of any given target date fund being just right for you for your entire life are slim to none. Case in point: the uproar in 2009, when funds targeted for people retiring that year took a beating, dropping up to 41% in value! But here’s the kicker — I’m not saying that the funds were poorly designed. I’m saying that they weren’t right for the people who were yelling about them, who didn’t fully understand what they were getting into. I would love it if there were an investment out there that magically tailored itself properly to the person who bought it; until that day, I highly recommend you roll your own “target date fund”. Don’t worry — it’s not nearly as complex as it sounds!

A quick primer on target date funds

A little review: target-date funds are mutual funds that are designed to achieve a certain goal, generally either retirement or college matriculation in a certain year. They do this by gradually changing their asset allocation from very aggressive (risky but long-term rewarding stuff, like international stocks)  at the beginning to conservative (stable but less long-term rewarding stuff, like short-term bonds) as the target date approaches. The idea is that you get the benefit of higher expected returns when you can afford to take the risk — and stability when you can’t.

This gradual shifting of allocations is called a “glide path”, and every fund company uses a different one. For some examples, check out this wiki page from our good friends the Bogleheads. It all looks very scientific, but truthfully, there’s a lot of guesswork involved — especially since the fund has no idea what you need. What if you plan on delaying social security claims, and thus having completely different income needs your first few years of retirement? What if you’re keen on leaving a legacy, and have more than enough money to handle market fluctuations? What if (as happened to a lot of folks in 2009) a drop of more than 10% in your retirement funds would cause you to panic, sell everything, and put it in cash, where it would subsequently get mauled by inflation? Each of those situations calls for a radically different allocation, but the target date retirement fund doesn’t know that, and if you don’t know that it doesn’t know, you may end up blindsided.

Building the glider: the basics

So, if a target-date fund could leave you high and dry, how do you go about building a replacement yourself? First off, don’t worry about creating a “glide path” that makes assumptions about what things are going to be like 20 years from now — the only thing you know for sure is that they’re going to be different. Glide paths are for institutions that don’t know your personal situation! Rather, you’re going to focus on the allocation that makes sense now, and you’re going to revisit this once a year. Once you’ve gone through the exercise once, it’s a breeze to revisit — just make sure you’ve got a calendar entry or reminder set up, or you may find yourself losing half your portfolio the year before you’re set to retire!

Really, it’s just a three-step process:

1) Determine your asset allocation: what percentage of your portfolio are you going to allocate to stocks v. bonds? International v. domestic? Small-cap v. large-cap? A lot of research has been done on this, but until (or unless) you dive in deep, there are some basic rules that will get you 90% of the way there.

2) Determine your asset location: how much of your portfolio is in a tax-advantaged account? Roth v. Traditional? Again, some basic rules will help you out.

3) Determine the funds you will use to implement your allocation. If all of your retirement is in a 401(k), this choice is often more or less made for you. If you have an IRA, then you’ve got a double-edged sword: you generally have access to better (cheaper/more transparent) funds, but the choices can be overwhelming.

And yes, once you’ve been at the investing game for a while, you’re liable to collect quite a handful of accounts — 401(k), Traditional IRA, Roth IRA, brokerage account, etc. etc…and one of each of those for your spouse, as well! This is where a rudimentary knowledge of spreadsheets — or a friendly expert who can set it up for you — comes in handy!

That’s it! Don’t worry, I won’t leave you hanging; the next few posts will go into detail on steps one and two. Stay tuned!

how to prioritize your savings when you’re fresh out of college (and later)

Now the real education begins.You’ve got a shiny diploma, thousands of dollars in student loan debt, and a dozen friends and relatives who each have their own idea about where your money should go. Buy a house! Pay off that student loan! Save for an emergency fund! Invest in your 401(k)! And, somehow, have money left over for, you know, food and stuff!

Fear not: I’ve got a system that can help.

Start off by putting a minimal amount towards every savings goal you have. You heard me: all of them. And when I say “minimal”, I mean it — even if it’s only 0.5% of your  paycheck into your 401(k), the minimum payment on your credit cards, and $20/month for your emergency savings fund, put something away towards each of your goals. The idea here is that you start saving right now, thus taking advantage of the mysterious force of compound interest that makes for interesting graphs like this (from this post). (And yes, compound interest has the same effect whether you’re talking about debt or saving.)

Of course, even compound interest isn’t magic enough to fund your retirement on 0.5% of your paycheck. Which is why the next steps are critical:

Every six months, increase the amount you’re putting away by a set amount. It doesn’t have to be a lot, but by periodically increasing the amount  you put away, you can slowly ramp up to your goal in small, painless increments. The money that would normally go to “lifestyle inflation” will instead go quietly, steadily towards your savings goals.

For instance, you might add 0.5% to the amount of your paycheck going towards your 401(k) every six months. In ten years, you’ll be putting an extra 10% away towards retirement, something a lot of people in their 50’s can’t say!

Meanwhile, choose your Most Important Goal and focus on that. All your savings goals are getting some attention; pick the most important one and give it some extra love. Allocate more of your budget to it; put a high percentage of all “found money” there (the rest you can spend on whatever you want, as an incentive to “find” more); in general, make it a high priority. Once that goal is taken care of, move on to another, and so on. This way, while you’re slowly building momentum on your other goals, you’re always focusing on the most important one. A suggested priority list for a new grad:

  1. One-month buffer
  2. High-interest debt, in order of size (snowball) or interest rate, whichever motivates you more
  3. Emergency fund (3-6 months’ basic living expenses or more, depending on your situation)
  4. Mid-sized savings goals, like your next car or the down payment on a house
  5. Low-interest debt
  6. Retirement

By the time you’ve worked your way down to “low-interest debt”, you should be in really good shape. Will it take a while? You bet. That’s the beauty of long-term goals, though — you have a long time to get them right!