Table of Contents:
Know Yourself First
In Part two of the experiment, I recommended Andrew answer two questions before starting down any investment path.
- Does this investment strategy actually match his goals, temperament, and interests?
- Is it plausible and likely to work?
Part 2 focused on establishing Andrew’s goals and exploring the plausibility and likelihood of achieving them. In this post we’ll focus on matching his investment strategy to his temperament and interests.
In our initial meeting, Andrew shared that he had read a bit about index investing and was leaning toward that approach. But he did not fully understand it.
What Is Index Investing?
Index investing was originally introduced to the general public by John Bogle and Vanguard in 1975. Bogle designed the first fund to track all of the stocks in the S&P 500 index. The basic concept is to buy a fund which holds a widely held selection of stocks based on a particular “index”. The index represents the entire stock market or a particular part of it, such as the S&P 500. Through the fund, you simply buy shares of every stock in the chosen index and hold them forever.
The theory is that by accepting average returns of the market, you will actually substantially outperform most investors and funds. This is because you avoid fees, taxation, and behavioral and timing errors inherent in trying to “beat the market”. Research has proven the theory over and over.
Andrew is establishing his career and has already developed a high savings rate. A DIY strategy of passive investing seems perfect for his situation. It’s proven to work, requires minimal time, minimizes expenses, and is tax friendly.
Sounds pretty simple, right? Except……
It’s Not That Simple
Let’s look at a sampling of the information about index investing produced on just this website in a recent two month period.
- JL Collins appeared on the Doughroller Podcast Episode 277 to discuss his “Simple Path to Wealth”. He recommends a strategy very similar to Bogle’s. He would advise someone like Andrew to put all of his money into one single fund, the Vanguard Total Stock Market Index (VTSAX). Then add to it with every paycheck, and don’t think about it again until he is ready to retire.
- Paul Merriman also appeared on the Doughroller Podcast in Episode 270 to discuss his “Ultimate Buy and Hold Strategy”. Merriman is also an advocate of investing in index funds. However, he recommends a portfolio of 10 different index funds representing 10 different equity asset classes in addition to allocating money to bonds. Historically this increases returns while decreasing risk.
- Low cost financial planner Mark Zoril was on Podcast Episode 268 to promote his $96 financial plan. He emphasized that most people will do well with a simple well diversified portfolio using a fund of index funds, a low cost target date retirement fund.
- Michael Pruser wrote a post explaining the difference between index mutual funds and exchange traded funds (ETF). Both traditional index mutual funds and ETFs track indexes and are characterized by very low fees and excellent tax efficiency. However, there are distinctions that may make one preferable to another for particular investors and particular situations.
- Robo-advisors advocate for the use of index fund investing using ETFs that track a variety of indexes. Each robo-advisor offers a unique approach to designing a diversified portfolio of ETFs and offers slightly different fee structures and services. Kevin Mercadante wrote an article on why you should use a robo-advisor and another on why you should not. Rob Berger weighed in on which robo-advisor is best.
Each of these interviews and articles contained excellent information. Each represented plausible solutions for someone like Andrew. The problem is trying to sort through all of the information and figure out how to apply it.
How can Andrew decide on a particular approach that best meets his individual needs and interests? What approach will prompt him to take action and get started? Most importantly, what will be the plan that he will actually follow for the long-term? He needs to avoid the biggest and most destructive mistake that investors make, jumping from strategy to strategy at the wrong time driven by fear or greed?
Where to Begin?
In our first meeting, I advised Andrew to take a break from listening to podcasts and reading blogs which were his primary sources of financial information. They were overwhelming him. His problem was not a lack of information, it was information overload.
I recommended two books for Andrew to read prior to a second meeting when we would begin working on his investing strategy. The goal was to give him a foundation on which to build other decisions.
The first book was JL Collins Simple Path to Wealth. As I wrote in Part 1: “It is written for beginners to be simple, entertaining, and easy to read. It simultaneously contains some very profound insights into building wealth, as well as technical and behavioral aspects of becoming a do-it-yourself investor.”
I also advised he read Rick Ferri’s All About Asset Allocation because “it gives an excellent overview of virtually every asset class in which you could invest.” I also wrote that reading it “will make Andrew much less susceptible to every ‘next big thing’ that he hears or reads about.”
Andrew and I then discussed different index fund investing strategies. Ultimately, the strategies can be broken into two categories. We discussed the positives and negatives of each.
Traditional index investing was described above. Andrew found aspects of this appealing. Most obvious is the simplicity. This is very easy to do yourself. It is also extremely cost and time effective.
I posed two question to Andrew about the dangers of this approach.
- This strategy currently looks amazing to a new investor looking only at the nearly decade long bull run domestic stocks have been on. But does he have confidence that he will stick with the strategy when the next downturn comes and he will be reading and hearing about it every day?
- Is he confident placing one bet on large American companies to be the dominant economic force in the world and pass up on other investment opportunities that also have strong past performance records? Will he remain confident indefinitely? Or will he be tempted to switch when his portfolio has a bad month, year, five years, or even a decade as is historically possible?
Modern Portfolio Theory
Modern portfolio theory starts with the basic tenets of traditional index investing including using low cost, tax efficient investments which track broad indexes. However, instead of choosing one fund or asset class, you add further diversification by spreading your investments across international funds. You may also choose to invest in sectors of the market divided by size (large, medium, small, micro) and/or perceived value (value, blend, growth). You may also invest in index funds representing other asset classes including bonds, real estate investment trusts (REITs), gold, etc.
Choosing this strategy comes with its own set of questions and problems. Here are a few we discussed:
- When there are reports every few days of domestic markets hitting new highs. Will he be willing to stick with a diversified? One that is more complicated and expensive while simultaneously underperforming the simpler, cheaper approach.
- In the long run a more diversified approach is likely, but not guaranteed, to outperform the simpler approach. Will he take comfort in that?
- Does he have the interest and ability to manage a more complex portfolio? Is he willing to spend time selecting initial investments and figuring out how to piece them into a portfolio? Will he be willing to do it again if he switches jobs and investment options in retirement plans change? Will he take the time to rebalance regularly?
- Does the potential of increased returns and decreased volatility of a more diversified portfolio outweigh the financial and time costs and increased complexity associated with building and maintaining it?
Time to Decide
He was armed with some knowledge of what he could invest in and the challenges of different approaches. It was time to start making some decisions. I emphasized to Andrew that I could not advise a particular strategy or particular funds, and all decisions were his. However, he should spend as much time as he needed working on the reasoning behind his decisions. And I would help him with this.
Initially, Andrew was stuck. He was uncertain how to allocate his new investments. He also was struggling to figure out what to do with the investments he had already accumulated and inherited.
Understanding Locus Of Control
I advised Andrew to focus on his locus of control. The “Serenity Prayer” summarizes this concept perfectly.
“Grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference.”
I emphasized to Andrew that becoming a successful DIY investor is not about trying to predict the optimum asset allocation or project future returns. Rather it requires de-emphasizing these things that he can not control and which are not knowable until after the fact.
Instead, he should emphasize things that he has great control over such as controlling savings rate, investment fees, limiting taxation of income and investments, taking an appropriate amount of risk, and developing processes to enable good behaviors and eliminate destructive ones.
The Best of Both Worlds
Andrew ultimately decided that he liked the simplicity of traditional index investing. However, he found value in diversifying risks. As well as having the potential upside rewards offered by modern portfolio theory. He wanted to add some diversification over traditional index investing while keeping his portfolio as simple as possible.
Starting With Asset Allocation
We discussed ways to get the maximum amount of diversification with the minimal amount of complexity. I recommended he look at the Bogleheads “Lazy Portfolios” as a basis for developing an overall asset allocation plan which he could then tweak to his preferences, risk tolerance, and available investment options. These “Lazy Portfolios” are designed to allow a person to choose a widely diversified portfolio of domestic and international stocks and bonds with minimal complexity.
Ultimately, Andrew decided to create his own asset allocation utilizing four asset classes in the following percentages:
- 45% Large Cap Stocks
- 20% Small Cap Value Stocks
- 20% International Stocks
- 15% Bonds
Again, we have no idea if this is an optimal asset allocation or even if it will outperform a simple S&P 500 index fund. The key here is that Andrew selected an allocation that he understands, one that gives him considerable diversification, and that he is confident he will stick with for the long term.
Better Reasoning Begets Better Results
In part one and two we belabored establishing the right goal to get Andrew started. On paper, the goal never changed. Andrew wanted to be a millionaire by age 40.
In this segment, we spent considerable time choosing a strategy and formulating an asset allocation. We acknowledge that we have no idea if they will be optimal.
The key point in both cases is establishing the reasoning behind Andrew’s decisions.
Building wealth is simple. Spend less than you earn, invest the rest wisely. Everyone knows this, but relatively few do it because they lack conviction and commitment.
The key to being a good investor is to get started and then avoid emotional decisions. Again, everyone knows this. Just “buy low and sell high”. It sounds so easy, yet few people actually do this. Instead, most people do the opposite because fear and greed ultimately prevail.
Many of the questions that we encounter in personal finance do not have a single correct answer. Therefore it is important to not worry about getting everything perfect. Instead, we should focus on developing reasoning behind our decisions, making decisions with confidence based on the information available, and then making it as easy as possible to take action to implement these decisions.
There are many things we actually can know and control with our investments. This is where we focused next as we actually went about implementing Andrew’s strategy. Going forward, we will discuss how Andrew determined what to do with investments he already held. We’ll also discuss how he can locate assets that are cost effective and tax efficient. Finally, we’ll look at ways to make managing his portfolio simple, and a key action to prevent making emotional decisions that derail many investors.