When people find out what I did for a living I generally ready myself for The Most Frequently Asked Question – “Do you have any stock tips” (or some variant thereof).
My answer is boring. Really boring.
My first response is a question – how much do you have saved up in liquid assets – cash, money markets, savings accounts – for emergencies. Do you have enough liquidity to pay all your bills (rent, groceries, insurance, utilities, etc.) for 6-12 months. “Yes” means we can keep talking. “No” means go save some money. Now.
Assuming the answer was yes we then move on to a spirited discussion of Index Funds. This generally meets with some disappointment.
Note: Everyone wants stock tips – although it was a lot worse ten years ago. Stock tips are for later on and they are generally not from me. Don’t need the aggravation. If something goes wrong you never really ever hear the end of it – even if its just a look. If it works they’re the genius for having listened.
So, back to Index Funds. Why? Because managers that can beat the market for an extended period are rare. Really, really rare. And the ones that do exist make you pay for that out-performance in higher fees.
A common mistake is to look at a manager who has outperformed the market in recent years (let’s assume the market has risen) and then view him as one of those rare managers who is a market beater. The far, far likelier answer is simply that he is taking more risk than the market. Taking on higher risk than the market in a bullish environment means you outperformed – or you should have. It doesn’t make you a great manager.
A corollary mistake is to chase these managers – jump on the fund-wagon so to speak. Why? Because by the time you have decided a given manager can beat the market he is already pretty deep into a given market cycle. Which means you are buying into a fund that is likely riskier than the market and towards the likely end of that current cycle. And high risk funds don’t perform all that well in a down or bearish cycle.
Index Funds don’t try to beat the market. They try to match the market. Sounds dull but it takes the emotion out of the equation and removes the wilder swings a manager can introduce into things. The market can already move pretty wildly on its own. Trust me on this.
Ok. So we agree that Index Funds are the way to go. Now a few more questions:
- Is your current job easy to replace if you lose it for any reason? If so your cash reserves are fine closer to the 6 month mark. If not then build those cash reserves closer to the 12 month mark.
- How many years until you plan to retire, when do your kids start college, do you have kids, when do you plan to buy a house? If you’re just starting out then great – you can take on primarily equity risk – you want capital appreciation. Your investment horizon is a long one – you can put the money into the market and “forget” about it. If you’re getting close to retirement then you should be thinking income, liquidity and capital preservation – high quality bonds are more your style. College tuition and the purchase of a home are other factors to weigh at this juncture. We are actually asking a simple question. How soon do you need the money back?
- How risk averse are you? Can you stomach big swings in the market or do you have a heart attack and call me because your portfolio had a tough day (I don’t answer the phone as a matter of principle). If your risk tolerance is high than that moves you to the equity spectrum (higher volatility, lower income, less liquidity, etc). If your risk tolerance is low then you want to be in liquid instruments that preserve their capital – bonds, government securities, municipals. The question here is are you willing to risk losing money in order to make money?
- What’s your tax situation? Nope, nope, nope – don’t tell me – make an appointment with a reputable tax person and go over your entire situation. The tax code stinks and I generally want no part of it.
What we have done by running through this stuff is important. We have:
- established your liquidity position and needs – what are your sources and uses of cash
- established your investment horizon – when do you need the money
- established your risk tolerance – can you handle market volatility
- taxes – again, all you
Now to the fund selection. Ironically, this is usually the easier bit. If you’re younger and have a high risk tolerance then we are looking primarily at equity funds. If you are older then you are on the bond, municipal, government security spectrum. You want safety and liquidity.
As an example if you are 32 years old with adequate liquidity, a steady job and you are already setting aside money for that home down payment then I would probably tell you to be in a mixture of small, mid and large cap stock funds along with a dose of international equity exposure. No income producing securities. We are looking for capital appreciation.
If you are older our focus shifts. We are looking to preserve what you have already made and we want to start shifting your assets to income producing securities. We would be looking at bonds, municipals, government securities, perhaps some dividend paying stocks, etc.
An important side note. If you own a home it is likely your biggest asset. Treat it as such. And avoid any incremental real estate exposure in your fund selection. You’ve already got plenty through your home ownership. And if you have a mortgage then what you really have is levered equity. What do I mean by that? Simple example: If you buy a house for $500K and put $100K down then the equity in your home is just that – 20% or $100K. If your home appreciates by 20% then the home is valued at $600K. But…your equity has just doubled and is now worth $200K. Sounds great – and it can be – but leverage works both ways. Now let’s say instead the real estate market is tough and your $500K house declines in value by 20%. Your house is now worth $400K and your equity is worth…$0. The power of leverage can be a great tool and often wins out in the long run but it can produce violent swings in your underlying equity and too much leverage can easily wipe you out. Be prudent with your leverage and respect how much you already have invested in real estate via your home ownership.
Now comes the really important bit. It’s time to decide how much and how often your money gets invested. For most everyone the best way to go about this is dollar cost averaging. Yet again, this sounds boring and it is. It’s also one of the surest paths to retiring better off than the next guy.
Simply put, with dollar cost averaging you decide now how much you want to invest each month and then you set things up where it simply comes out of each paycheck and straight into your chosen funds proportionally. This accomplishes a bunch of things. It keeps you on a budget. It removes emotion from the decision making process (it essentially removes the decision process which is even better). It means you buy a greater number of shares when the market is going down (it’s now cheaper per share). It means you buy a smaller number of shares when the market is going up (it’s more expensive per share). It completely removes the temptation to “time” the market – well you still may be tempted but we’ve locked you in.
Now you are done – you sit back and you…ignore the market. Don’t look. No really, I mean it. Don’t aggravate yourself – stick to the strategy and let it take care of itself. You’ll be better off in the long run. The only two things you need to do are 1) have more of your paycheck invested as your earning power increases and 2) re-balance your portfolio mix every now and then if it gets out of whack through market moves. What I mean here is simply to keep your proportional investment balances roughly in line percentage-wise over time. As an example, if your small cap fund swelled in value where it now represents a larger proportion of your portfolio then it did when you started you should probably re-balance by moving some money out of the small cap fund and into the other funds.
You do have some long-term responsibilities. Specifically, you need to adjust your portfolio to your own changing risk and liquidity profile over time. If nothing else, as you get older you will be incrementally lowering risk and increasing liquidity.
Lastly, see a tax specialist as needed because, as I said, the tax code stinks and I want no part of it.
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