Rule 1 of 3 for Retirement Investing:
- Put your money where it averages the greatest returns long term (10+ years)
- Treat retirement accounts as insurance for not having money when you’re old
- Passive indexing and rebalance periodically
First, you need to accept a truth about investing
Professional fund managers (stock pickers) can’t consistently pick winning stocks. Due to the highly volatile nature of stocks, it may appear that a fund manager is doing a great job any given year, but if you compare their performance over a long period of time, you’ll see most of them can’t outperform the S&P 500. The S&P 500 is an index that tracks the performance of the largest 500 US companies.
The Rise of Index Funds
John Bogle created the first index fund in the 1970s and he basically figured out that these fund managers couldn’t beat the Indexes on a consistent basis. So Bogle started Vanguard and created the first Index Fund. An index fund is a fund you can buy like any other stock or fund, but it is basically buying a fund that tracks an index. For example. a S&P 500 index tracks the largest 500 US companies, so buying a S&P 500 index fund is like buying all 500 companies at once.
Active Investing vs Passive Investing
Active Invested Fund is one where a fund manager picks which stocks to put in a fund. He supposedly an expert on this and he generally will charge a fee for his services like 1.5% of money invested. A Passive Invested Fund is where a computer tracks an index and doesn’t have to do any picking. Just a little work to manage money and some paperwork and therefore the fee on this is considerably less. Basically what i’m saying is Active Investing sucks and if you want more info and proof on it, read my post on Active vs Passive Investing.
Benefits of Indexing
- Save time by taking the guess work out of what to invest in
- Save anxiety by not studying and following stocks every day
- Low Fees and when it comes to long term investing and compound interest, it’s a big deal
- Better Performance. Sure a fund manager might beat an index 1 year or maybe even 5 years, but over 10+ years, they aren’t going to especially if you factor in their fees
- Diversification. When you buy a index fund, you’re investing in a bunch of companies at once
Ok, so we now know to buy index funds. But there are so many, which ones do we buy? You’re bread and butter is going to be a low cost S&P 500 index fund like VOO and a low cost US bond fund like BND. If you want to keep it simple, you can get buy just owning these 2. The dividing of your assets is called Asset Allocation.
VOO tracks the S&P 500 Index which is equities and fairly volatile. In 2008 the index fell by something like 40%, granted that was one of the worst stock crashes in history. Since then the S&P 500 has fully recovered and gone way past pre-crash peaks. But this does show how volatile equities can be.
BND tracks the US bond market. Bonds are loans given out and in general a much more stable investment. With less volatility, bonds will generally pay out less return on average.
The rule of thumb in if you are planning on investing your money long term then you have handle the big swings of equities to seek the higher returns. So if you’re far from retirement, you’ll want to be heavily invested in the S&P 500 vs Bonds. As you near retirement age, you’ll want to switch more to bonds and less equities. You don’t want to loose 40% of your money in a year when you’re 60. That kind of a swing can screw your retirement plans and probably take off a few years of life too.
Expanding Your Portfolio
Different combinations of funds will give you some flexibility and maybe you like a particular industry. I personally think Biotech and Bioengineering is a growing field so I own a the fund XBI which tracks a Biotechnology Index. I also own a Real Estate Fund for fun and to be more diversified.
Rebalancing Your Portfolio
Rebalancing is the process of adjusting your Asset Allocation. Let’s say you’re young and want to do a 90% equity / 10% bond allocation. You spend 90% your money on VOO and 10% on BND. Over the next year, equities do really well and now your equities make up 95% of your portfolio’s value. To rebalance, you need to sell off some of VOO and buy BND with that money making your split 90% / 10% once again.
Tips on Rebalancing
- Rebalancing once a year is all it takes
- If there is crazy stock volatility you should be rebalancing more often. The goal is to stick to your Asset Allocation (90/10, 50/50, or whatever it may be)
- As you get older, you may want to change you Asset Allocation to a more conservative ratio
If you’ve ever played around with stocks, the question is always, when should I sell it? I don’t know about you, but this has given me me anxiety in the past. If equities do well and you have to rebalance, this forces you to sell and take those gains. Ahhh, no more guessing game!
Will Markets Go Up Forever?
This whole long term investment strategy is based on the premise that the markets will always go up and the US will never be bankrupt. Yes and that is a scary thing to accept for some. I don’t fully believe 100% that will continue even in my lifetime, but as of now this is the best bet. Here’s a short list that may help alleviate some worries.
- Historically, the markets have continued to grow and hopefully they will continue to grow at least in our lifetime.
- Rich is getting richer. That means big companies are getting bigger. The S&P 500 tracks large companies and benefits from this.
- Rich getting richer means wealthy people are getting wealthier. The wealthy are the ones who owns stocks, so as they continue to get richer, where do you think they will be putting their money? I’m guessing the market.