January is a good time to step back from the detail of your investing activities and consider whether your big-picture objectives are being met. Whether you're a new reader putting together a personalized long-term investing plan for the first time, or a grizzled veteran for whom this is old hat, it's worth quickly reviewing these core principles. As the seasons of life change and events influence your financial condition, it's appropriate to review and perhaps tweak your long-term approach. This guide, coupled with Austin's January editorial, should help you with this task.
If 2011's investing experience could be distilled into two words, we would nominate uncomfortable and indecisive. Investors were kept on edge throughout the year.
After setting highs in the spring, stock prices sold off and continued erratically downward. On October 4, the market fell enough intra-day to satisfy the bear market definition of a decline of 20% from the highs, but before the closing bell reversed course and closed just above that level and has stayed comfortably above it since. Did we experience a bear market, or didn't we?
The economy sent mixed signals throughout the year as some reports seemed to indicate a new recession will be avoided while others suggest it won't be. Are we in a recovery, or aren't we?
Europe provided its own on-going drama with its leaders repeatably claiming to have solved their sovereign debt difficulties (sending the markets soaring), only to see new roadblocks quickly surface (sending the markets plummeting). Will they solve these problems, or won't they?
The market's actual performance numbers for 2011 paint one picture, but investors' emotions paint quite another. The S&P 500 stock index opened the year at 1,257 and was at 1,255 at the time of this writing (mid-December). Dull, yes. But many investors felt as though 2011 had put them through the wringer. The emerging field of behavioral economics helps explain why this is. Research shows that investors suffer the pain of losses twice as acutely as they feel the joy of gains. So when volatility increases, sending the markets soaring and then plummeting on a seemingly daily basis, the result is not benign just because major indexes end up at roughly the same levels from which they started. From an emotional standpoint, the daily ups and downs don't offset each other. Rather, the sharp down days do "double damage" — the corresponding up days only offset half the effect. The market may go sideways, but investor sentiment falls nonetheless.
Unfortunately, you can't control the rate of return you earn — at least not in the stock market. But there are many aspects of investing that you can control. Focusing on the things you can control is an effective counter-weight to concerns about the market (or the economy, or Europe, or the election, etc.).
As a new year begins, we thought it would be helpful to step back for a moment and review the core building blocks of successful investing. Newer readers will surely benefit from a quick survey of these core principles. Seasoned investors should benefit as well — it's all too easy to get bogged down by increasing layers of complexity as the years pass. Even if you've been at this investing thing for a while, consider this an opportunity to review and confirm that your past decisions in each of these areas still make sense given your current season of life and the progress you've made toward your goals.
There are a great many items we could include in a list of investing core principles. But in order to focus this discussion more firmly on the investing process itself, we've made a few assumptions up front. We're assuming you're already utilizing a spending plan (aka a budget). Most people never make genuine financial progress without one. Simply put, creating a budget and living by it will likely make a greater impact on your financial life than anything else you can do. This is the mechanism by which you match up your income and expenses, and it is your budget which creates the monthly surplus that makes financial progress possible. Without a budget, you're likely trying to harness the wind.
While on the subject of tilting at financial windmills, if you're not giving generously, make this the year you begin. Scripture is full of promises for generous, cheerful givers. Though counter-intuitive, giving generously is a key component of building financial security because it invites the Lord's blessing.
We're also assuming you're rid of most, if not all, consumer debt. (If you still have debt other than your mortgage, focus your efforts there first.) Likewise, we're assuming you have a reasonable savings reserve. Building a reserve is your second priority before beginning to invest. The investing principles discussed below can wait until you have these two pieces in place.
Living on a budget, living debt-free, and having a reasonable emergency savings reserve are the bedrock we're building on. From there, you're ready to begin your investing journey. Here are five basic principles to help get you where you want to go.
1. Write it down! the importance of your long-term plan
Many people think they have a long-term investing plan. And they do. Sort of. At least until the market drops 10% in two weeks. Then they realize what they really have — which is a collection of ideas about how they might want to invest. Guess how much those vague ideas are worth at 3 p.m. on Wednesday when the market is down 4.5% for the day with no bottom in sight?
In contrast, SMI is built around the idea of creating a personalized, long-term investing plan and putting it in writing. Don't neglect this last part. Putting pen to paper (or pixels to screen) forces you to become much more precise, concise, and specific. These are exactly the qualities your plan will need to truly be helpful at 3 p.m. on the aforementioned Wednesday when the market is tumbling and your emotions are screaming at you to end the pain.
What needs to be included in your long-term plan? A good place to start is with a few brief financial goals. Prayerfully set, and agreed upon with your spouse if you're married, these written goals can motivate you to stick to your plan.
Your personal applications of the remaining four principles discussed in this article will constitute a significant portion of your long-term plan. But before moving on to those, here are a few keys to make your plan useful.
Key #1: Success in investing comes not in hoping for the best, but in knowing how you will handle the worst. Nobody really knows what is going to happen next year, next month, or even next week. Your plan must allow for the fact that the investment markets will experience unexpected rough sledding every now and then. That's where diversification comes in. The idea is to pick investments that "march to different drummers." This means your strategy involves owning a mix of investments that are affected differently by economic events. For example, you might invest in both a bond fund and a gold fund. When inflation really heats up, bonds go down (due to rising interest rates) while at the same time gold goes up (because investors want a secure "store of value"). To the extent that the price changes in the two funds offset one another, you have added stability to your overall portfolio.
Key #2: Your investing plan must have easy-to-understand rules that are clear-cut. There must be no room for differing interpretations. You must be able to make your investing decisions quickly and with confidence. This means reducing your decision-making to numerical guidelines as much as possible. A strategy that calls for a "significant investment" in small company stocks is not as helpful as one that calls for "30% of your portfolio" to be invested in small company stocks. In so far as possible, your strategy should not only tell you what to invest in but also offer precise guidance in telling you how much to invest and when to buy and when to sell.
Key #3: Your investing plan must reflect your current financial limitations. Your plan should effectively prevent you from taking risks you can't afford. The words "higher risk" mean there's a greater likelihood you can actually lose part or all of your money. Every day, people who mistakenly thought "it will never happen to me" find just how wrong they were. Money is not an abstract commodity. For most of us, it represents years of work, hopes, and dreams. Its unexpected loss can be devastating. Only when you are out of debt and have an emergency reserve are you financially strong enough to bear the risk of loss that is ever present in the stock market.
Key #4: Your investing plan should reflect a balance between your emotional "comfort zone" and your need for capital growth. Your plan should prevent you from taking risks that rob you of your peace. That's why we start with a personality quiz in the next section — to help you decide which investing temperament is best for you. You shouldn't embrace a strategy that takes you past your good-night's sleep level. If you do, you will tend to bail out at the worst possible time. On the other hand, you can't set your risk level so low that you have no chance of meeting your long-term goals.
The process of thinking through and actually writing out your personalized long-term plan will help create the "inside-out" perspective that SMI believes is so important. And the process of periodically referring back to your plan helps maintain that focus as the years pass and you're tempted to add complexity to your investing efforts.
2. Carefully consider your most important investing decision
What determines the performance of your investment portfolio more than any other single factor? Many investors think it's the specific investments they choose. Certainly those choices can make a big difference. But even more important is how much of your portfolio is allocated to stock-type investments and how much to fixed-income securities such as bonds. Academic studies over the years have established that as much as 90% of your long-term results can be traced to this fundamental allocation decision.
A portfolio's stock-to-bond mix does more than dramatically influence future returns, it also tells you how those results are likely to be obtained. Generally speaking, the more bonds in your portfolio, the smoother the ride. By contrast, the higher your stock allocation, the more you can expect returns to come in a "two steps forward, one step back" fashion.
If owning stocks subjects you to greater swings in performance and produces losses more frequently, why use them at all? Because that's where the biggest long-term gains are! The net effect of all those stock market ups and downs is greater overall returns. So, on the one hand, we have stocks, which are volatile but produce high returns. On the other we have bonds, which are relatively stable but produce lower returns. How should you go about combining them in a portfolio?
The key ingredient in this recipe is time. Over shorter periods, stock returns are much more variable. Maybe you'll do great; maybe you'll do poorly. Given a long time frame, however, you can be confident that stocks will provide higher returns than bonds.
Here's a good example to illustrate this point. Think about tossing a coin. You know that the probability of getting heads on any single toss is 50%. So if your goal is to get 50% heads, then what matters most to you is having a lot of tosses. If there are only going to be two tosses, you should be much less confident of getting 50% heads than if there are going to be ten tosses. With 100 or 1,000 tosses, your confidence should grow correspondingly that the long-term averages will emerge.
So it is with investing. The more years ("tosses") you have ahead of you to invest, the more confident you can be that you'll benefit from the higher average returns stocks have historically provided. The fewer years you have to invest, the more you need to protect against the possibility that the results over your shorter time period may not match the long-term averages.
That's why it's generally recommended that younger investors take advantage of the many "tosses" in their future by investing heavily in stocks. They can afford to ignore the short-term ups and downs, while focusing on the highest long-term returns possible. Later, as you move closer to retirement and the number of future tosses declines, it's prudent to scale back the short-term risk of loss by gradually increasing the percentage of bonds held in the portfolio.
The allocation of a portfolio is the primary driver of both its expected returns and volatility. If you're nearing the end of your investing time frame (whether for retirement, college, etc.), this information should give you confidence that you can keep growing your money at a reasonable rate even if you do the prudent thing and decrease your stock holdings to reduce the chance of short-term losses. Conversely, if you still have many years to invest, understanding this should liberate you from worrying too much about recent stock market losses and help you focus on the higher long-term returns stocks have historically provided.
3. Maximize tax-advantaged opportunities
Taking maximum advantage of the opportunities provided by the government to delay or avoid taxation of your investment earnings is a key component to building long-term wealth. Yes, you can invest in a regular taxable brokerage account, but you'll advance much more quickly — and likely wind up keeping much more of your earnings overall — if you take full advantage of the retirement savings plans provided by employers (401k, 403b, etc.) and/or IRAs.
Describing all the account types and how to decide between them is too detailed a discussion for this article. But here's a broad overview. 401(k) plans and IRAs come in two types — "traditional" and "Roth." Traditional 401(k) plans and IRAs allow savers to defer taxes now and pay them later. Retirement savers get an up-front tax deduction when they deposit into the account. Their earnings then grow tax-deferred, and they pay tax on all of the withdrawals (both their original principal and all earnings) in retirement. The Roth versions of these plans flip the tax equation: pay taxes now, make tax-free withdrawals later. After-tax money is deposited initially, which makes all later withdrawals (principal and earnings) tax-free in retirement. Which approach is better largely depends on whether you end up in a higher or lower tax bracket in retirement. (See Making the Most of Your IRA Opportunities.)
Roth accounts would seem to be more advantageous, but that isn't always the case. With "traditional" accounts it may appear that, at best, you're merely postponing your taxation day of reckoning. But keep in mind that most people are likely to be in higher tax brackets now (while they are working and saving) than during retirement (when their employment income has stopped). This means they may pay significantly less taxes on investment gains later, as opposed to paying them each year while earning employment income.
Granted, these retirement accounts have more strings attached than a taxable brokerage account, so you do lose some flexibility. But that's a reasonable tradeoff to make for most people.
It's also worth noting that these tax-advantaged accounts have income and contribution limits. So it's worth making an effort to start utilizing them sooner rather than later. If you put off making these deposits until other financial goals are achieved, you may find yourself unable to take maximum advantage. For example, the limit on annual IRA contributions is currently $5,000 per year for those less than 50 years of age. If you forego making a contribution one year, it's gone forever — you can't make a double contribution the next year.
4. Choosing the right investment strategy
What makes an investment strategy the "right" choice? It's not always an easy decision. The most important point is that you believe in whatever strategy you choose enough to stick with it during the inevitable downturns. Every strategy will falter occasionally. Bailing out at those times in search of a better-performing approach is the strategy equivalent of buying high and selling low — not a good formula for building long-term wealth.
Sound Mind Investing offers two primary investment strategies: Just-the-Basics (JtB) and Upgrading. Here's a brief overview of each.
Just-the-Basics is the epitome of simplicity. Using just three or four Vanguard index funds (depending on your chosen portfolio mix), JtB seeks to match the return of the overall market. Research repeatedly shows that the average investor typically trails the market's rate of return, usually by a significant margin. JtB ensures this won't happen to you by delivering returns roughly equal to that of the market. As an added bonus, it is an extremely easy, low-maintenance way to invest, requiring attention only once per year.
Upgrading is a trend-following strategy that attempts to beat the market by continually adjusting to the types of investments the market is currently favoring. In Upgrading, we rank more than 1,500 mutual funds by type each month and determine which ones have been delivering the best recent performance. We recommend the purchase of the top funds in each of five SMI risk categories. These funds are held until they stop outperforming. At that point, we recommend replacement funds that are showing stronger recent performance.
Upgrading works because, as economic conditions change, market leadership rotates among different investment approaches and companies of different sizes. But even though conditions are constantly changing, fund managers rarely do. Managers who excel under one set of market conditions often stumble under a different set of conditions. So, rather than buy a fund and hold it through both the periods that favor the manager's approach and the periods that don't, Upgrading continually guides us to funds that are currently in favor.
Thankfully, choosing between JtB and Upgrading is easier now than it used to be. It used to be that anyone who didn't want to pay attention to their investments on a monthly basis was more or less forced to choose JtB. However, with the creation of the professionally managed SMI Funds several years ago, Upgrading is now an option not only for those who enjoy handling the process themselves using the newsletter recommendations, but also for those who prefer to delegate their monthly Upgrading duties via ownership of the SMI Funds. Upgrading has held a consistent performance advantage over the past dozen years or so, though JtB has been keeping up well over the past few years. For most investors though, SMI recommends Upgrading as its preferred strategy.
5. Run your retirement numbers and make adjustments
This may seem a bit tricky, but it doesn't need to be. First, you need to periodically re-visit the first four steps on this list (as well as revisiting your budget), much as we're doing this month. Your budget won't likely be the same at age 30 as at age 50 — and neither will your asset allocation. Life happens — an illness, job change, unexpected blessings that cry and need their diapers changed — these and a thousand other factors may cause you to adjust your plan as you go. That's okay. Just don't abandon your old plan without putting a new plan in place.
On the purely investment side, things are a little more rigid — you shouldn't make changes to your plan just because the market is down 25% and you're feeling queasy. But if you come across new information or a new strategy that makes you honestly (and unemotionally) believe that a change is warranted in your plan, there's flexibility to build it into your plan. (Austin's editorial this month is a good example of tweaking the specific makeup of a plan while maintaining its long-term framework.) Circling back to where we started though, you need to make sure any changes are inside-out (based on your needs and goals), not outside-in (based on the news of the day).
In addition, we strongly recommend running your retirement savings numbers periodically. Every few years may be often enough for some; others may prefer to do it more often, perhaps annually. SMI offers two ways to do this. Our online Retirement Planning Calculator is the easiest approach. In addition to handling all the math for you instantly, the calculator allows you to make entries into online worksheets which are then stored for you in your account. This makes revisiting them every so often a piece of cake. However, the old-fashioned pencil and paper approach still works too. The retirement worksheets can be found on pages 244-252 of The Sound Mind Investing Handbook and are also included in the Counting Down to a Financially Secure Retirement [PDF] bonus report.
The tricky thing is knowing what to do when running your numbers reveals a shortfall. If you find that you're behind schedule on your retirement savings goals, there are two main things you can do. The safe approach is to increase your savings while keeping your portfolio allocation and strategy selection unaltered. This is the preferred approach. While it's not easy, it is safer because you aren't asking too much of yourself emotionally, as can be the case when you step beyond your ideal allocation or strategy selection.
If you absolutely can't find the extra savings to plug the hole, your options are more limited. Either you need to scale back your retirement assumptions (when you will retire or how much income you hope to have in retirement), or you need to add more risk in pursuit of higher investment returns. We write it that way intentionally to drive home the riskiness of this approach. Boosting your stock allocation from 60% to 80% may not seem like a big deal — until the next bear market rolls around and you're outside your emotional comfort level. Similarly, adding a higher-risk strategy, such as SMI's advanced Sector Rotation strategy, may seem like an easy way to boost returns. Just be aware that with those higher returns comes higher risk and volatility.
Higher risk always accompanies higher-return strategies. Attempting to recover from investment declines by pursuing higher-risk approaches has been the downfall of many investors throughout the ages. Better to make realistic adjustments to your retirement plans by delaying retirement an extra year than risk completely blowing up your portfolio in pursuit of higher "make-up for lost ground" returns.
These steps aren't comprehensive in terms of taxes, estate planning, insurance, and so forth. But they do provide a helpful guide for gauging your fundamental investing needs and getting started. The primary obstacle for most people as they travel down the road to financial freedom is not a lack of a "perfect" plan — it is simply inertia. If you can get going with these bases covered, you'll find there's plenty of time to fine-tune things as you go.