Investing...
This page is an attempt to quantify my thoughts and strategies on investing, with the goals being to
analyze and sharpen my own methods, and to provide guidelines for others travelling along the same path.
Personal Finances
Before even considering whether you should be investing, make sure that your personal financial house is in
order, and by that I would suggest that as a minimum you have satisfied the following...
- Live Within Your Means: be aware of your spending habits, and don't spend more than you bring in.
- No Debt (other than home): all credit cards paid in full every month.
- Cash Reserves: 3-6 months living expenses in a bank or money market account.
- Insurance: adequate life, health and disability for your current situation.
Pay Yourself First
Once your personal finances are in order, your next goal would be to get into the habit of regular savings.
Depending on your budget, decide on a percentage of your income that you are going to save every month (be it 5% or 25%),
and then treat that amount as a regular monthly bill that you are required to "pay" along with your other monthly bills.
Setting up automatic investment programs that deduct money right out of our checking account will make this process
almost painless once you get used to the idea of that money not being around for you to spend.
If you're not familiar with the power of compound interest, take a look at these tables,
which show how quickly your money will grow given a certain rate of return and number of years.
Money which you will need to spend in the next few years should NOT go into your investment accounts, as you don't want to be
caught in a market down turn just when you need the cash to pay for a car, school or whatever.
That short-term money should just be lumped in with your cash reserves.
As to where all this investment money you're saving is actually going, there are two distinct types of accounts you
will have:
- Tax-Sheltered Investment Accounts:
These are accounts in which your money is allowed to grow tax-free until you retire, and you should attempt to
contribute the maximum amount you can to all tax-sheltered accounts available to you.
These would include IRAs (Roth, regular, and educational), employer sponsored plans (401K, 403),
and self-employed plans (Keough). Sock all you can into the tax-sheltered accounts,
as this is where you can take the most advantage of the power of compound interest growth.
- Taxable Investment Accounts:
After topping off your tax-sheltered accounts, any other savings you have will go into your taxable accounts, which
simply means accounts on which you have to pay yearly taxes on things like interest and capital gains.
Risk vs Reward
So where exactly do you invest the money in your investment accounts
for the greatest return? One iron-clad rule of investing to keep in mind is that high returns equals high risk.
Putting all of your money into one high-flying technology stock
might provide spectacular returns, but it may also bring equally spectacular losses.
On the other hand, putting all of your money in a savings account is very low risk,
but that low-risk investment also brings very low returns, and may not even keep up with inflation.
Finding the right mix of risk and reward for you will involve some serious personal assesments of how much risk
you are willing to take, and it may take some time for you to find the right balance that still lets you sleep at night.
Modern Portfolio Theory
After dabbling in many investment stategies over the years (with mixed success), I've finally settled on one that
seems to promise the highest returns with the lowest risk, and that is one based on
Modern Portfolio Theory (MPT), a 1990 Noble Prize winning theory discovered by Harry Markowitz.
In a nutshell, MPT describes how dividing your investments into non-correlated asset classes can lower its overall
risk while at the same time increasing the overall return. Having non-correlated asset classes means that when one
asset class is going down, another would be going up, and that by having the correct proportion of your investment in each
asset class you can hit a point where your risk as measured by standard deviation is minimized and return is maximized.
How you actually choose which asset classes to invest in, and in what percentages, is the tricky part of MPT.
I would strongly recommend spending some time reading about MPT, and a terrific starting point would be an online book
called "Investment Stategies from the 21st Century".
Another would be a fantastic book by William J. Bernstein called
"The Intelligent Asset Allocator".
Mr. Berstein also maintains a web site filled with content
(including the first two chapters of his book)
at Efficient Frontier.
Tracking the Indexes
After deciding on an allocation strategy, it is then just a matter of deciding where exactly to put your money so that
it can track the different asset classes.
One way to do it is by buying mutual funds that track an index.
You can sign up with a mutual fund family like Vanguard Group or Dimensional Fund Advisors (DFA), both of which have a terrific selection of
indexed mutual funds with very low expense ratios, and then spread your money between the different funds in that family.
However, I uses another investment vehicle instead of mutual funds, and that is something called an
Exchange Traded Fund (ETF).
These act like mutual funds, but trade like a stock on the exchanges, so you need a brokerage account to buy them (I use TD Ameritrade).
Using a brokerage account lets you buy any mutual fund, ETF, or stock you want, so you are not restricted to one particular fund family. Below you can see the ETFs that I use
in my accounts, and you can now find an ETF for almost any asset category you can think of.
MPT Asset Allocation
After digesting the above reading, I then had to decide exactly how I was going to divide up my funds. For someone at my age and risk tolerance level, I decided to maintain a 20-25% level of bonds, split equally between US and International bonds. The stock portion I then split equally between US stocks and international stocks, as the US makes up roughly 50% of the total world stock value. The table below shows my current breakdown, and a list of the ETFs I'm using to make up each category. Note that some categories are further subdivided into US/International/Emerging, large cap/small cap, and value components.
| Asset |
Pct |
Sub-Asset |
Sub-Pct |
Exchange Traded Fund (ETF) |
| US Stocks | 30% |
| |
|
| |
Large Cap | 15% |
VTI,
VTV |
| |
Small Cap | 15% |
VB,
VBR |
| International Stocks | 30% |
| |
|
| |
Developed | 20% |
VEA,
EFV,
SCZ,
DLS |
| |
Emerging | 10% |
VWO,
DEM,
DGS |
| Bonds | 22% |
| |
|
| |
US | 11% |
BSV |
| |
International | 11% |
BWX |
| REITs | 10% |
| |
|
| |
US/Intl/Timber | 10% |
VNQ,
RWX,
PCL,
RYN |
| Commodity Futures | 8% |
| |
|
| |
DJ-AIG | 8% |
DBA,
DBB,
DBE,
DBP |
Investing in even just the first three main asset categories should give you lots of diversification, and the others I'm using should provide even more non-correlated assets without too much more complication. The Coffeehouse Investor has another
recommended allocation
which may be of interest.
More on Bonds
Instead of buying a bond fund, you can also buy and hold bonds individually, but given the risk in holding individual
issues, I would limit the bonds to US treasury issues. I buy TIPS (see Andrew Tobias write up)
for tax-sheltered accounts, and I-Bonds (see Andrew Tobias write up)
for non tax-sheltered accounts.
Links
e-mail to carl@griceland.com