In a prior post, I discussed how investing in the stock market is actually pretty simple.
As a quick review, the stock market as a whole is a (relatively) safe investment.
The overall stock market has always – repeat always – gone up over the long-term (>10 years).
Index funds are funds that contain stocks representing a large portion, or all, of the stock market. There are also index funds for bonds and even real estate investments.
By investing in index funds with money that you do not need for a long time (>10 years), you are investing without the need to predict the future or time the market, which has consistently been shown not to be possible over the long term.
While the decision to invest in index funds may seem like a no-brainer (it is!), there are still a mind-boggling variety of ways that one can go about this.
It can seem overwhelming and lead to analysis paralysis, where we don’t act because we are so caught up trying to figure out the best or perfect way, when there is no such thing.
Once you decide to invest in index funds, there are a few basic steps that will lead you from idea to action:
- Determine your asset allocation
- Buy funds according to your asset allocation
- Rebalance your asset allocation according to a set schedule
Let’s go over each of these steps:
1. Determine your asset allocation
Step #1 is where most people get hung up.
There are so many different asset allocations and we can get so worried about picking the right one. But the trick is to realize that there are no right asset allocations. There are also few wrong asset allocations. That’s why the White Coat Investor lists 150 Portfolios Better Than Yours.
The important thing is that you pick one and stick with it.
Let’s figure out one possible asset allocation right now. First, what percentage of stocks and bonds?
A good starting point is your age (rounded to nearest 10) minus 10 for your bond percentage. I’m 32 so that would mean 30% bonds.
Now, think if you would like to be more or less aggressive. The further into the future that you are planning to need your money, the more aggressive you may generally be.
If you’re more aggressive, do less bonds. Less aggressive? Do more bonds.
Next, figure out how you want to split up your stocks.
There are U.S. index funds, international index funds, large cap index funds, small growth index funds. To start, you don’t need to get caught up in all of this. It is perfectly reasonable to decide to split your stocks between U.S. and international index funds for diversification.
If you would like to include real estate in your portfolio, you can include real estate investment trust (REIT) index funds at the percentage of your choosing. If you don’t want to include this, then don’t.
The important thing to remember is that you are betting on the overall market, which has always gone up. Some asset allocations may go up more than others over the next 20 years. But it’s impossible to predict which will and which won’t, so don’t get caught up trying to figure out the impossible.
Just pick one and stick with it.
For the sake of this post, let’s say we pick a perfectly reasonable asset allocation like:
40% Total U.S. Stock Index Fund
40% Total International Stock Index Fund
10% REIT Index Fund
10% U.S. Bond Fund
2. Buy funds according to your asset allocation.
Now, we take the sum of money that we are planning to invest. Let’s say it is $100,000. Through simple math, we know that we are planning to invest:
$40,000 in a Total U.S. Stock Index Fund (40% * $100,000 = $40,000)
$40,000 in a Total International Stock Index Fund
$10,000 in a REIT Index Fund (10% * $100,000 = $10,000)
$10,000 in a U.S. Bond Fund
So, we now purchase a corresponding fund for each class.
There are considerations in terms of which types of account (taxable, non-taxable, tax-free, tax-deferred) to invest each fund in. This will be covered in a coming post.
The important thing to understand for now is that each account that we invest into need not have the same asset allocation so long as all of our accounts put together contain our goal asset allocation.
For instance, our 401(k) may have 100% U.S. stock index funds. This is ok so long as that means it has $40,000 worth of U.S. stock index funds and our other accounts (457, IRA, taxable account, whatever they be) have the other corresponding allocations properly represented.
In looking for which specific funds to buy, search for index funds in the brokerage of your choice or those offered by your employer or self-directed retirement accounts. For instance, Vanguard offers the S&P 500 Index Fund. This would be a great choice for your total U.S. stock market allocation.
In general, look for broad index funds representing a large portion of its particular class with a low expense ratio (<1% for sure, Vanguard’s are often 0.15% or less) and low turnover ratio. A low turnover ratio means that the fund is not buying and selling different assets all the time. It’s an index fund, it just tracks the index and should not need to buy and sell a lot. If the turnover ratio is high, it’s not really an index fund.
3. Rebalance back to your asset allocation according to a set schedule
Ok, so now you have determined your asset allocation and bought funds according to your asset allocation. What next?
When investing in anything, the goal is to buy low and sell high. Then you earn the difference between the buying price and the selling price.
But how can you do this in the market without timing it or guessing the future, which we cannot reliably do?
It’s actually incredibly simple.
After you buy your funds in your asset allocation, do nothing. Then once or twice a year, rebalance your portfolio back to your set asset allocation.
Here’s an example of how to do this.
Some years, stocks will do better than bonds and REITs.
At the end of the year using our example, you may have 90% stocks, 5% bonds, and 5% REITs (because stocks performed better).
To rebalance, you would sell enough stocks (you are selling high) and buy enough bonds and REITs ( you are buying low) to get an allocation back at 80% stocks, 10% bonds, and 10% REITs.
Do this and you are guaranteed to ALWAYS sell high and buy low.
Alternatively, you can divvy up whatever new funds you will be investing in the correct proportion to rebalance your asset allocation back to its predetermined percentages. This way, you can just buy low and don’t need to sell (and risk any tax implications).
Now sit back another year and do the same thing.
Rinse, lather, repeat.
You are now investing without needing to predict the future (impossible) or constantly stalk the finance pages (misleading) in a manner guaranteed to have you buy low and sell high (that’s how you make money, right?).
What do you think? What is your asset allocation? How often do you rebalance? Have you ever bought high and sold low? How can you avoid that in the future?