Believe it or not, the best investment isn’t the one with the highest returns. It’s the one you can stick with.
Saving and investing both inside and outside retirement accounts is a great way to grow wealth and build resilience for the future. In fact — every one of us eventually is going to have to start living on our own wealth when we retire. In order to be successful, you have to remain invested for decades and be patient year in and year out.
Yet, there’s so much misinformation out there. The sad thing is – 90% of all financial news is directed at hot stock tips, short-term trends, and day traders — not the vast majority of people trying to meaningfully grow their wealth so they one day don’t have to be dependent on a job for income. I think the show Mad Money, if you’re familiar with it, is called that because it’s completely mad to watch the stock market day by day and hour by hour. But that’s essentially what you have to do to make money by choosing individual stocks and even so, you’ll probably guess wrong more than half the time. What a waste of time — especially since you have a day job.
“Don’t look for the needle in the haystack. Just buy the haystack!”― John C. Bogle
This quote by Mr. Bogle is classic and this is why this article isn’t going to be about which companies to buy or whether you should “get in” on a hot new investment product. Because as I said — in investing it doesn’t really matter what the investment is doing now. It matters what the investment will do in the future and whether it’s something you’re prepared to stick with for decades despite ups and downs.
When should I start picking stocks?
Actually, I don’t recommend choosing individual stocks. In order to be resilient, we need to avoid concentrating our our real money in any one company that could go belly up during a bad PR flub or by running afoul of a new regulation or new consumer trend. That means you essentially have to buy them all — or at least a large portion of all the stocks that exist in the world.
From the time we’re kids if you’ve ever been exposed to investing you were probably taught to buy individual stocks, watch them, and see how you do. This is the old model of investing. It doesn’t reflect all the latest available research.
Studies show that investors who behave this way barely out earn inflation, according to a study by JPMorgan. This is largely because when you own individual stocks, you’re more tempted to sell when markets go down (because of fear of losing) and buy more as markets are going up (because of fear of missing out). You should actually do the opposite to be a good investor.
Diversification, as the quote by John Bogle is trying to describe, is the idea of not putting all your eggs in one basket. Timing doesn’t matter as much because you’re buying to stay invested. The best course of action is to spread your investments across industries, countries, and different types of securities and account types. We can do this through low cost “index funds,” “mutual funds” and ETFs.
This strategy of owning a little bit of everything will smooth out the impact as the market has its ups and downs.
How Should I Choose Index Funds?
Because there’s such a preoccupation in the media with returns and “getting in” while you can, this tends to permeate our thoughts when we choose investments for our own retirement portfolios.
A common way people choose investments for their portfolio is to simply pull up the sheet that shows investment performance for each fund option and chose a handful with the highest returns.
The problem is, what’s NOT listed on this sheet is a graph showing all the market hiccups and jumps you’ll have to experience in order to arrive at that stated average annual return.
Small cap stocks (which are the smallest publicly traded companies by market cap), because they have a long way to grow often have the highest average annual returns — perhaps 12%+ per year on average.
However, the variability in those returns will put any investor on a wild ride. One year could be up 150% another year you could be down 80%. That’s tough for anyone to stick through. If you happen to start your investments in a year where these stocks are doing poorly — you might make a change to your investments and then you’ll NEVER, ever get the chance to earn those “outsized” returns.
That’s why it makes more sense to diversify — not just by purchasing one or two index funds which collectively allow you to own hundreds of stocks. But, by making sure that your asset allocation matches the global stock market.
That means you need to have some bonds (preferably a mix of corporate and government bonds) and some stocks (preferably a mix of sizes and countries represented).
Fun Fact: we often refer to stocks by their relative market size. Large cap stocks for instance, are the largest publicly traded companies like GE, Apple and Ford. You can probably recognize or name many of them. Sometimes people refer to these as Blue Chip Stocks, other times it’s known as the S&P 500. When you buy the S&P 500 you’re not buying the “entire stock market” only the largest 500 companies. So while that’s a lot of companies, it’s still not actually very diversified.
Mid cap stocks and small cap stocks are basically just smaller-sized companies, they don’t have as many shares outstanding maybe the price of their shares are a bit lower. You probably aren’t able to name or recognize many of them if you saw them listed on the exchange.
When we talk about stocks too we need to make sure that we own the global market, not just companies in the United States because it can be really easy to have a home country bias. Much of the growth that is happening in the stock market is probably not going to happen in the US because it’s a saturated market. There is a limit to how many more people can be reached here. So, we also want to own international stocks: not just from the developed economies we know like Japan and Europe, but also from emerging markets like Africa, and Southeast Asia. Each country has its own risks, but there is certainly a lot more potential for growth abroad than in the U.S.
You have to look at each of these pieces as a percentage of your total portfolio. Bonds should be anywhere between 10%-40% of your portfolio and stocks should be between 60%-90% of your portfolio (for the vast majority of people). Any thing more or less than that and you’re probably taking on too much risk and will likely experience more fluctuations in your retirement account balance.
The choice of exactly where you should land on this spectrum depends on your own timeline for retirement. Got decades before you retire? You can probably chose 80%-90% stocks because you’ll earn more in the long run. Have less than a decade before retirement? You should probably choose between 60-70% stocks. The higher the allocation to stocks, the more ups and downs you’ll have to endure (since stocks are more risky than bonds), but if you have a long time until you need the money you can afford to wait it out to get the higher returns. This is definitely an individual choice and a financial advisor can give you good advice about what your specific allocation should look like.
However, “Target Date Funds” often create an asset allocation for you which correspond to a stated retirement date range. These can be good for novices or people who don’t have time or energy to do the research I’m talking about above. However, be aware that the “target” they are shooting for is quite large — meaning it won’t reflect your specific needs or timelines. I find that these funds tend to be more risky in the early years and too risk averse leading into retirement. Sometimes these funds are much more expensive to purchase and own (see more on this below).
How do I maximize my returns?
Actually, it’s quite simple and boring. You set your asset allocation and stick to it. Staying invested is the only chance you have of earning the printed long-term average annual returns.
The lesson here is: Don’t try and switch out funds to get better returns. If you try and time the market, you can make costly mistakes.
Fun Fact: Market corrections happen more often than birthdays. It’s important to remember we can plan for market corrections, they aren’t to be feared. We know they will happen, we just don’t know exactly when. And opportunities exist when markets go down.
- We can buy more stocks and bonds at a discount
- We still receive dividends and interest even during market down turns and those funds can be reinvested at a discount.
- We can purposely sell positions that have gone up to rebalance them by purchasing more of assets that have gone down.
- If you get out of the market when markets go down the biggest risk is you won’t be invested during the recovery, which often happens much quicker than anyone believes (and is reported on far less by the financial media).
So then, how do I maintain my investing strategy?
As time passes some investments will do better or worse than others. You won’t be able to avoid losses and it’s a bad idea to attempt to. The latest Nobel prize research says it’s more important to just maintain your original asset allocation.
Let’s say you originally set out to have 80% stock funds and 20% bond funds in your portfolio.
By the end of the year, the stock portion could be at 85% and the bonds will have shrunk to 15% of the portfolio because stocks tend to grow much faster than bonds.
When this happens, it means you have to sell some of the stocks to get back to 80% and buy some more bonds so that they equal 20% again. This is the epitome of selling high and buying low — following exactly the right advice you’ve been given in school.
However, this is where the challenge and the work lies with investing. With retirement accounts like 401ks, usually there’s just a button that says “rebalance” and they do the work for you. In fact, you should set up an auto rebalance twice per year if the option exists in your 401(k).
When you’re investing outside of retirement, perhaps on a monthly basis, you should be using your new money along with the dividends and interest you’re earning to buy asset classes so that they match up to your original strategy. Just make sure you don’t pay too much attention to headlines while you’re doing this.
What I do for my private clients is offload that work so that they don’t have to spend hours each month messing with spreadsheets to figure out what they should buy more of or agonizing over how to maintain the asset allocation.
What About Fees and Expense Ratios?
As we discussed, most people choose funds to according to stated returns. But did you know every fund option you’re being given is associated with an annual fee known as an expense ratio? These fees can be wildly different depending on the fund choices your company offers you. So, screening fund choices by expense ratio should be the first thing you do.
Avoid funds with high expense ratios because they erode returns. Look for the lowest possible expense ratios of less than 0.20%.
You can find expense ratios on a fund’s prospectus. A prospectus is a regulatory document that the Securities and Exchange Commission requires all investment funds to create. You might have to hunt for it, but a listing of fees and expense ratios should be available for each of the fund choices in your retirement plan.
This article called out some some major investing pitfalls to avoid. They are:
- Getting caught up in stock picking instead of buying the whole market
- Focusing only on returns rather than considering how much risk you’re taking on
- Picking funds based on feeling rather than facts and strategies.
- Forgetting to rebalance — set it and forget it only applies to the original investment choices. There’s still maintenance that you must do.
- Not paying attention to fees and expense ratios
Remember: The best investing strategies are boring and requires consistency and many years to fully play out.