Earn More with Index Funds in 2013 and Beyond
Assume you are tasked with designing an investment portfolio and can’t change it for the next 20 years. How would you proceed? There are three steps to the process. First, decide on a sound philosophy; second, create a strategy that fits the need; and third, adopt a simple way to maintain discipline. These are the three keys to long-term investment success.
Decide on a Sound Philosophy
Philosophy is a big picture concept about how the markets work and how to invest in them. The decision tends to fall down to whether you want to be passive or active. Passive is a mostly hands-off approach that’s based on a long-term market commitment, while active is a hands-on approach that is based on trading.
The simplest way to explain passive and active investing is with mutual funds. Most people invest today using mutual funds and exchange-traded funds (ETFs), so let’s start with three facts about long-term fund investing that will help you make a philosophical decision.
Fact #1: In every investment category, a low-cost passive index fund or ETF that tracks a market performs better than the majority of actively-managed mutual funds that attempt to beat the market.
Fact #2: A portfolio holding only low-cost passive index funds or ETFs in every asset class has outperformed almost all portfolios that hold actively-managed mutual funds.
Fact #3: Maintaining a passive fixed allocation to asset classes outperforms almost all active tactical strategies that attempt to trade in and out of asset classes.
These three mutual fund facts are iron-clad over the long-term. Time and again researchers have shown them to be true. This includes several Nobel Laureates. Attempts to refute these facts are rooted in marketing hype and data manipulation by active investment firms that charge high fees and fail to deliver superior returns.
If you believe these three facts, then you’ve also embraced a passive philosophy. A passive investor doesn’t try to pick active funds the might outperform and they don’t try to earn excess return by shifting money around based on a speculative belief. For more details, see The Power of Passive Investing.
Create a Strategy that Fits Your Need
Strategy is how each investor implements a passive philosophy. This typically begins with an asset allocation decision and then moves on to individual index fund selection.
Asset allocation is divided into two parts. The first part is mathematical and the second is emotional.
The math behind asset allocation involves the collection and analysis of numbers. These numbers include, but are not limited to: how much you’ve saved; the amount you’ll need; the point in time when you’ll need it; cash accumulation and distributions each year; how these accumulations and distributions may shift over time; an expected future tax and inflation rate; the amount you wish to leave to heirs after passing on; and finally, long-term asset class expected risk and return.
Collecting and analyzing this data allows you to pragmatically make decisions about asset allocation. This is done in two parts. First, you’ll need to figure out the rate of return that’s needed to achieve your financial goals. Second, this rate of return is then matched to the expected returns of the asset classes to find the allocation in stocks, bonds, and cash that best fits the return requirement. The allocation is further divided into sub-categories for more diversification, such as U.S. equities, international equities, Treasury bonds, corporate bonds, etc. For details, see All About Asset Allocation.
The second part of asset allocation is emotional. The math part tells you only what’s needed, it does not tell you if you can handle the risk associated with the asset allocation. The math and emotion must work together for success. In Chinese philosophy, the concept of Yin-Yang explains two complementary forces interacting to form a whole greater than either separate part. It’s the same concept here.
Emotion is the biggest detriment to a well-designed asset allocation because it’s the least understood and most overlooked part of the process. Many investors thought they had the right asset allocation based on their mathematical needs going into the financial crisis in 2007. Little did they know that after losing 20, 30, 40 percent or more that they would have a strong emotional reaction to the loss and pull the plug, often near the market bottom. Many of these investors then stayed out of the market until well after it turned higher, adding salt to the wound.
There is no easy way to determine how much risk you can handle in a portfolio until you actually lose money. The trick is to be no higher in risk than you can handle, including a margin of error. So, how do you determine this level?
Consider how you reacted in the past. If you were one of the people who sold out in the last market plunge, then whatever level of risk you were at before selling was obviously too high. I recommend coming down at least 10 percent in equity to find your maximum threshold.
Some people use risk tolerance questionnaires that they find online. These tools often hint at a maximum risk amount, although they are never accurate. Beware that some questionnaires push people into the most risky investments, even when it’s not needed, because the company providing the model sells risky assets. Others questionnaires are ambiguous and poorly written or may rely on only a few questions. If you do use a questionnaire, my recommendation is to answer questionnaires only after a large drop in stock prices. I believe it’s best to wait until after feeling pain so you’ll get a more truthful indication of where your risk tolerance lies. Adjust your asset allocation as needed after making this determination.
After you've determined your asset allocation strategy based on the mathematical and emotional elements, you can begin selecting index funds or ETFs to represent the asset classes selected for your portfolio. There are many competing index funds and ETFs to choose from. I suggest staying with a mainstream company such as Vanguard. It was the first index fund provider and they remain the largest. Other companies have their own line-up of index funds and ETFs including Barclays iShares, Fidelity and Charles Schwab. For more information, see All About Index Funds and The ETF Book.
Discipline is the practice of maintaining a well-conceived investment strategy. It’s probably the hardest part of investing. There is so much noise in the marketplace that one can easily be distracted from adhering to a strategy. It would be nice if we could put a portfolio strategy on autopilot and do a Rip Van Winkle for 20 years. While that’s not possible or desirable (I don’t want to sleep for 20 years), there are some solutions.
A balanced mutual fund of index funds is diversified across many asset classes and is automatically rebalanced when allocations drift. Vanguard’s LifeStrategy funds are appropriate for this purpose because they maintain a fixed allocation to each asset class. Several fund companies offer similar products.
You can also use a trusted investment adviser, such as Portfolio Solutions. A registered adviser works with you one-on-one to determine your appropriate portfolio and then implements and maintains this portfolio for an annual fee. Management fees vary considerably among advisers and they can be either a fixed rate or variable based on the size of an account.
Start the New Year right with a change in how you invest. All that’s needed is a sound philosophy, a portfolio strategy that fits the need, and a way to maintain discipline. These three keys will help you earn more in 2013 and beyond.