Saturday, April 14, 2012

Back to Basics

For some time I’ve been posting about specific topics like CDs, I Bonds, Reward Checking accounts, Vanguard Target Retirement and LifeStrategy funds, etc. I’ve decided that it’s time to review the basics. If you want to read another perspective on the basics of investing, a good resource is the Bogleheads Investment Philosophy. Watch the video version of it if you learn better by watching and listening to someone speak. For fun, I am  writing this without referring to those resources. Let’s see how many points we agree on (feel free to check). Here we go …

LBYM (Live Below Your Means). You can’t invest if you don’t save. You can’t save if you don’t spend less than you earn. If you can’t do that, you can stop reading now, and come back when you can. Read a good book on saving and budgeting instead of reading this. There probably are hundreds of books written on this topic; I’m sure you can find a good one at your local library. One I recently checked out, just to review, is The Smartest Money Book You’ll Ever Read, by Daniel R. Solin. In this book Solin refers often to as a good resource for learning about saving and budgeting, as well as providing tools to help (but I haven’t checked it out personally). Note that Solin also is the author of one of my top five recommend books for novice investors.

Develop an Investment Policy (IP). Just like it sounds, this is the policy you commit to follow in how you invest, what you invest in, etc. Some people think it’s important to write it down as an Investment Policy Statement (IPS), and even sign it! For details on an IPS, see the Bogleheads wiki article Investment Policy Statement.

Determine your risk tolerance, specifically how much risk and what types of risk you should take. This is a critical element of your IP. Although here I use the term risk tolerance, most authors use this term to refer only to the emotional aspects of how much risk to take. There’s more to it than that. Risk and expected reward are related (no pain, no gain), but it is not wise to take more risk than is warranted by your unique situation.

Decide on an Asset Allocation (AA) that matches your goals and risk tolerance. This also is a key element of your Investment Policy. This is something you can control, and that has one of the biggest impacts on the long-term performance of your portfolio (your collection of investments). You can’t control the market, but you can control your AA.

Keep costs low. (see my blog post Costs Matter). This is another thing you have some control over, and that can make a huge difference in the long run. If you only have expensive choices in your 401k or 403b, it may be difficult, but do your best. Other Bogleheads and I spend a lot of time on the Bogleheads Investment Forum helping investors select the best funds in their 401k and 403b plans.

Don’t try to beat the market—it’s a loser’s game. There is ample evidence that most investors, professionals as well as amateurs, fail to match long-term, broad market returns by stock selection and market timing. It’s unlikely that you can do it. It’s unlikely that your stock broker or active mutual fund manager can do it.

Keep it simple. If all of your investments are in IRA accounts (Roth or Traditional), you can get by with as little as one index mutual fund, such as a Target Retirement or LifeStrategy fund. If you have a 401k or 403b plan with lousy choices (high expense, actively managed funds), then you might have to use a few funds, maybe coordinating with better choices in your IRA. If you have taxable as well as tax-advantaged accounts, you probably need at least three funds for optimum tax efficiency. You don’t need to use more than a few mutual funds, and you probably shouldn’t do so unless you have spent enough time learning about investing to understand the additional risks you are taking by doing so.

Stick to your plan (your IPS or at least your IP). This is most important when things are really scary, like during a big bear market (when stocks drop a lot in value), but also when the market is booming. In the bear market case, your IP probably should dictate that you keep buying stocks, perhaps by selling some bonds, but definitely by putting new cash into stocks. In the booming market case, your IP may dictate that you sell stocks and buy bonds, or at least put new cash into bonds. Of course when I say “stocks” or “bonds” I mean stock or bond mutual funds.

Tune out the noise. (see my blog post Financial News: Worse Than Useless) Do not pay attention to the financial news, investment “gurus”, or what your friends are saying about the economy or financial markets. Whatever you are hearing is already reflected in stock and bond prices, so it’s too late to do anything about it. Academic research has shown that no one is very good at predicting the future, expert or not. Tuning out the noise makes it easier to stick to your plan. There is an entire academic field of research, Behavioral Finance, that studies how investors make poor decisions based on their emotional reactions. Tuning out the noise is one tool in combatting this tendency.

Pay attention to the research. All of the above points are backed up by 60 years of research by academics and major financial institutions like Vanguard (Vanguard has a number of excellent research papers on their institutional website). The ginormous financial industry would have you believe otherwise, since it’s the only way they can make money. Most of the financial industry is interested in making money from you, not for you. A blog post about this is in the works!

No comments:

Post a Comment