How to make investment decisions

We covered this briefly in the previous section but, for the most part, the riskier your investment is the more returns you’ll earn from it over time. Risk cuts both ways. Meaning that, depending on the investment you are choosing, the value of your investment could drop precipitously or be completely wiped out (if you’ve chosen something very risky like a single stock).

 

You can balance out some of the risk of a given asset class by diversifying within it and, on an overall level, allocating your investments to a mix of asset classes. To decide how to allocate your investment money you’ll want to think through the following things:

 

  • What level of risk are you comfortable with?
  • Should you hold multiple portfolios?
  • How can you use index funds to your advantage?
  • How involved do you want to be with your investments on a regular basis?
  • Should you try and time the market? 
  • Who should I invest with?
  • What options do you have available to you for employer controlled, non-taxable investments?
  • Will you want to adjust your risk profile over time?

What level of risk are you comfortable with?

Generally, when it comes to investing money you’ll want to find the investment opportunity that matches your risk tolerances. Riskiness of your various money storage options are as follows (least risky to most risky):

 

  • Cash holdings (checking account, actual cash on hand, etc)
  • Bonds
  • Stocks (also known as equities)
  • Real estate
  • Private company shares
  • Speculative investments (crypto, shorts, futures trading, etc)

 

Another rule of thumb is that the more diversified your investment is, the less risky it becomes. So, even though stocks are generally riskier (and provide higher returns) than bonds, holding a stock index fund could be less risky (and provide a lower return) than an individual bond.

 

The generally accepted rule for the highest consistently returning mix of assets (in the financial independence community) is buy index funds and have 80% – 100% of your investments in equities and 0%-20% in bonds. This mix gives you a consistently high return (~7% in the US market) without too much variation on a medium to long term basis. Of course, you’ll see dips in valuations (ranging from the dip at the beginning of 2019 to the massive crash in 2008) but your investments will grow along with the overall economy and are tied to the actual value that companies are creating in the stock market.

 

Here’s some more reading on allocations:

 

https://www.financialsamurai.com/the-proper-asset-allocation-of-stocks-and-bonds-by-age/

https://www.reddit.com/r/financialindependence/comments/8vxacm/anyone_100_in_equities/

https://www.gocurrycracker.com/path-100-equities/ 

https://jlcollinsnh.com/2014/06/10/stocks-part-xxiii-selecting-your-asset-allocation/ 

 

Here’s a great tool to play around with to better understand how certain allocations can affect your chances at achieving financial independence:

 

http://www.cfiresim.com/faq.php | http://www.cfiresim.com/ 

Why does diversification matter?

Using a sample stock market with 6 stocks and which is worth $100,000 overall. 

  • Stock A’s market cap (overall value on the stock exchange) is $20,000
  • Stock B’s market cap = $10,000
  • Stock C’s market cap = $15,000
  • Stock D’s market cap = $40,000
  • Stock E’s market cap = $5,000
  • Stock F’s market cap = $20,000

 

If you were to buy $10 worth of stock A you would be fully exposed to that single stock. That heavy exposure cuts both ways. If Stock A’s value doubles then suddenly your investment is now worth 2x ($20) what it was worth before. However, if the company goes bankrupt (unlikely but possible) or suddenly drops 30% in value then your investment will shift in value by exactly the shift in the stock price.

 

Of course, you may not fully commit to a single stock. You’ll probably choose a set of stocks that you feel comfortable investing in. Perhaps that set of stocks is as many as 15 stocks. But how do you know which stocks you should buy? Are you a domain expert? Do you have a special understanding of how a stock should perform relative to all the other options available to you? Will your choice of stock(s) outperform the market as a whole?

 

At some point, it becomes unrealistic to expect to be able to follow a basket of stocks to the point where you can more accurately choose when to buy and sell better than the professionals who are attempting to do the very same thing (and not successfully in the long term – see the section on index funds below). Hence the benefits of diversification! 

 

You choose what kind of exposure you want to risk and buy into overall asset classes rather than specific stocks. In the case of equities, this means that when Stock A drops in value by 30% you have only a 6% in your overall portfolio (30% decrease x Stock A’s 20% share of the market).This also means that you benefit from increasing value in stocks that you would never have thought to buy or perhaps never heard of. This brings us into the topic of index funds (the best way to access overall asset classes efficiently and at low cost)!

Should you hold multiple portfolios?

Bear in mind that the bulk of this post pertains to investing for the long term. If you have a significant expense coming up in the near → medium term (less than 5 years) you should hold that portion of savings in a different (read less volatile) allocation mix. See When will you need the savings to be available for your goal? (https://docs.google.com/document/d/1tL2Y9PzffqLKGZUEGU4e90ye6u3l7rvTP3bQDDDDDFk/edit#heading=h.4k9k1b7e6bov) for the relevant reading in the Saving for the Future post.

 

Basically, depending on the time horizon that you’ll need the money for, you may want to have separate portfolios for your different needs. One for long term retirement (25 years out) where you’re allocated 90% to stocks and 10% to bonds, another for your housing fund (3 years out) where you’re 50% stocks and 50% bonds and another for short term, unexpected expenses (emergency fund, potentially 0 days out) where you’re entirely in liquid, non-volatile assets (so a high yield checking account). The sooner you need to access the money the less volatile you’ll want your chosen allocation mix to be.

How can you use index funds to your advantage?

There is a wealth of research that shows that the best (in this case, resulting in the highest possible consistent gains) approach to investing is to make use of index funds. Index funds allow you to access the entirety of the market that you’re buying an index fund for (US stock market, US bond market, international stock market, etc). 

 

Because index funds are simply buying into each company within that market at a rate that matches their share of the overall market the expense ratios for these funds are very low. As a result, you get diversified exposure that evolves as the market changes without having to attempt to buy miniscule portions of each share on your own. 

 

Another advantage of index funds is that the low fees allow you to capture the majority of the growth in your investments for yourself. Even if actively managed funds may occasionally outperform the market they get dragged down by their fees and underperform index funds in the long run (on average with 75%+ of mutual funds underperforming at the end of a 10 year period when compared to index funds). 

 

A simple explanation of an index fund would be as follows:

 

Continuing with our stock market example, the market is composed of 6 stocks and worth $100,000 overall. 

  • Stock A’s market cap (overall value on the stock exchange) is $20,000
  • Stock B’s market cap = $10,000
  • Stock C’s market cap = $15,000
  • Stock D’s market cap = $40,000
  • Stock E’s market cap = $5,000
  • Stock F’s market cap = $20,000

 

If you were to buy an $10 of an index fund that represented this overall stock market you would be putting your money into those companies at the following rates:

  • $2 into A, $1 into B, $1.5 into C, $4 into D, $0.5 into E and $2 into F

 

That example is heavily simplified but you can look at something like VTSAX (Vanguard’s Index fund for the US Stock Market – https://investor.vanguard.com/mutual-funds/profile/vtsax ) and see that the top 10 companies represent 18.81% of their net funds. So, when you’re buying shares in that index fund, ~%19 of your money is going towards investments in those companies with the remaining portion being broken down amongst everything else that is listed on the US stock market.

 

Because of your easy access to this tool for investing across a broad range of assets at a low cost you can quickly arrange a portfolio that matches your allocation target and put more money into the market with minimal time spent on managing what you’re buying in particular. By managing your risk across asset classes rather than on a per stock basis, you avoid overexposure to any single stock and benefit from overall growth in value for that asset class. 

 

See Warren Buffets bet against hedge funds as an example (https://www.investopedia.com/articles/investing/030916/buffetts-bet-hedge-funds-year-eight-brka-brkb.asp)

Take a look at this paper from Vanguard explaining the advantages of index funds (https://personal.vanguard.com/pdf/ISGIDX.pdf

More reading on the differences between index funds and actively managed funds

(https://www.nerdwallet.com/blog/investing/index-funds-vs-mutual-funds-the-differences-that-matter-most-to-investors/ )

How involved do you want to be with your investments on a regular basis?

Some people like to set up their investments and then completely forget about them (one of the best approaches to investing as you won’t get emotional and sell things in a downturn). Others like to check frequently, see how things are going and make adjustments. Depending on what you’re comfortable with, you’ll want to find a cadence to check in on your investments that makes sense for you.

 

I would recommend setting up automatic withdrawals from your checking account and having those be invested according to your allocations on a schedule that works for you. I, for example, have automatic investing set up with Vanguard where I pull $1600 from my checking account every two weeks (a few days after payroll hits) and put $1200 into VSTAX (https://investor.vanguard.com/mutual-funds/profile/fees/vstax) and $400 into VTIAX (https://investor.vanguard.com/mutual-funds/profile/fees/vtiax) which roughly matches my allocations of 66% domestic equities and 33% international equities (I also put my Roth IRA contributions into VTIAX to balance out to ⅔ and ⅓ overall).

 

If you’re ok with checking in quarterly to see if your allocations need rebalancing you can just choose individual funds to make up the mix of investments that you’re looking to. When you rebalance, you’ll either sell funds and buy others to get back to your target allocation (e.g. 90% equities, 10% bonds) or change your contribution mix (e.g. ¾ stocks and ¼ bonds instead of 0.9 stocks and 0.1 bonds) until it returns to the mix that you’re aiming to keep in your portfolio. Here’s a great paper from Vanguard (https://www.vanguard.com/pdf/icrpr.pdf) on why rebalancing is important and best practices for it.

 

If you prefer not to have to think about your investments after you’ve initially set them up, you can choose a fund that contains your target mix and automatically rebalances for you. The expense ratios for these funds tend to be more expensive than their component parts but keeping you on track with your investments and preventing you from avoiding it due to fear of complexity can make it well worth it. VTTVX (https://investor.vanguard.com/mutual-funds/profile/VTTVX) is an example of this sort of fund it is composed of 37% global equities, 26% domestic bonds, 25% international equities (non-US only) and 11% international bonds with an expense ratio of 0.13% (pretty good rate for a fund like this). This fund is meant for people who want to retire in 2025 so they gradually adjust the allocations to less risky assets as the fund gets closer to the intended retirement date.

 

Both of these approaches are good. Just choose something that works for your situation and don’t let yourself get too worked about changes in the market. Do some research, choose an allocation that works for your situation and stick with it. 

 

Should you try and time the market? 

It’s tempting to think that you can guess the right time to buy and sell things so that you come out ahead of someone who is putting a specific sum in at regular intervals (also known as DCA or dollar cost averaging). Heck, even it comes to mind for me sometimes and I have to remind myself of a few things to rid myself of the temptation.

 

  1. No one can time the market. Not you, not the high flying hedge fund manager, not even a sophisticated AI (at least we’re not there yet. And when we do reach that point other sophisticated AIs will make it so that the market can no longer be predicted because they’ll distort predicted outcomes with their own intersecting predictions). You may think it is easy to know when things have gone fully downhill or are at a peak that is going to tumble at any moment but it isn’t and you simply can’t know the optimal time to invest.
  2. You earn dividends from holding stocks. If you’re holding off on buying you’re losing out on potential appreciation for your equities and you’re also missing out on earning income from those stocks.
  3. By committing to a specific sum at regular intervals you’re taking emotion out of your investing strategy and naturally mitigating your risk of buying at market highs. Your investments will gradually grow as a result of your contributions and long term growth in the market.

 

Time in the market beats timing the market. Since you can’t guess where peaks and troughs are going to be, your best bet is to choose a regular amount to invest with at your given allocations and play the long game. 

 

Here’s a visual representation (https://imgur.com/gallery/BlK4jzM ) of a few different people who either pursued DCA, got extremely lucky with timing the market or unlucky with timing the market. I found it to be very helpful in demonstrating the upsides of such a strategy.

 

As an additional example, Fidelity found that their best performing investors were actually ones who had passed away. Since they were dead they weren’t there to jump in and fiddle with their investments and they stuck to the strategy they’d chosen initially (https://www.reddit.com/r/financialindependence/comments/4u4pd3/article_2014_fidelitys_best_investors_are_the/)

 

More resources on DCA:

https://www.reddit.com/r/financialindependence/comments/c02ml4/timing_the_market_the_absolute_worst_vs_absolute/?sort=top

https://www.nerdwallet.com/blog/investing/dollar-cost-averaging-2/ 

 

Who should I invest with?

I would recommend using Vanguard because they are owned by the shareholders of their funds (https://about.vanguard.com/what-sets-vanguard-apart/why-ownership-matters/) this means that they will always act in your interest instead of making plays to gain market share and then taking advantage of their consumers in the future. Additionally, they are consistently the best or one of the best with regards to fund choices, expense ratios and customer service.

 

If you do want to play the game of switching providers if you are being mistreated, then Schwab or Fidelity are good choices (more to consider here – https://www.bankrate.com/investing/best-online-brokers-for-mutual-funds/). Do bear in mind that there is a chance that you’ll need to shift your accounts in the future which can be a headache (although it’s a small risk if you choose a reputable provider). 

 

Generally, you should choose a provider who will be able to give you access to the range of investments that you want to put your money into.

What options do you have available to you for employer controlled, non-taxable investments?

Given that you’re choosing where to put the investments that you have control over (any non-employer controlled plan) this mostly applies to things like your 401k where you can’t choose who you’ll be investing with.

 

For example, my company recently switched from Vanguard to Fidelity (which sucks for me since I prefer Vanguard). They had a bunch of terrible funds with really high expense ratios but i was able to filter down the choices available to me to get to a mix of funds that was roughly representative of what I’d been putting my money into at Vanguard (add details on this process – three fund mix).

 

You’ll want to look for a mix of diversified index funds with low expense ratios (should not exceed 0.5% and ideally are below 0.15%) that match your asset allocation targets.

 

In short, your options may be limited depending on where your employer has chosen to set up your 401k but you can usually work within those constraints to set up a mix of funds that is decent overall. Your available options would have to be tremendously bad to warrant not putting money into that 401k at all (due to the tax advantaged nature of the contributions you make to it and the potential for employer matching).

Will you want to adjust your risk profile over time?

As you get closer to your planned retirement date, the number of years in which you’ll be earning income will decrease as will the years left until your retirement. This will have the dual impact of you not being able to recover as easily from a reduction in value of your assets by putting aside money that you’ve earned or simply waiting for your assets to recover. Because of this, you’ll likely want to reduce the riskiness of your investments as you get closer to your retirement age. 

 

I would recommend using Vanguard’s target retirement funds as a guideline for the allocations that your investments are composed of as you get closer to your planned retirement age. See them here (https://investor.vanguard.com/mutual-funds/target-retirement/#/) or look at the breakdown of allocations by years to retirement that I put together here (https://docs.google.com/spreadsheets/d/1wM4UqiUoNRLeLBXFf18LndKSJccok_iwXheELCisaY4/edit?usp=sharing). 

 

Years to Retirement Stocks (%) Bonds (%) Short term reserves (%)
0 51.4 48.59 0.01
5 61.11 38.88 0.01
10 68.47 31.51 0.02
15 75.84 24.14 0.02
20 83.38 16.6 0.02
25 89.83 10.15 0.02
30 89.81 10.15 0.04
35 89.79 10.15 0.06
40 89.81 10.14 0.05
45 89.88 10.12 0

 

As you can see from the table, Vanguard’s allocation remains at 90% stocks, 10% bonds from 45 years to retirement all the way up until 25 years to retirement. It then moves to 16% bonds with 20 to go, 24% with 15, 31% with 10, 38% with 5 and 48% with 0 to go.

 

Again, if you don’t want to be as involved in the regular management of your funds, you can just choose a target retirement fund with good investment strategies and a reasonable expense ratio and let it take care of things. Otherwise, you can check in on an annual basis and gradually increase your holdings of bonds in accordance with your reduced risk appetite as your retirement date nears.

Links

International vs. Domestic (US) Equity Allocation


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