This blog is dedicated to “pursuing the truth in all four realms.” So by definition, that would include the world of money. I intend to take some time and talk about money over the next few blog posts, starting with a simple way to invest for retirement.
I am a believer in finding the “simple” on the other side of complexity. Whether we are talking computer programming, theology, politics, or finances…finding a simple solution (but not simplistic) is the key to solving many of life’s problems. Of course knowing the solution (eat less and exercise more) and doing it…are two separate things entirely and gets us into theological areas…so we’ll skip that for now.
For those who find finances challenging…investing for the future is a veritable labyrinth of choices and often one falls back on the “priests” of the financial world to exclaim the “runes” of a mutual fund prospectus or current IRA regulations. Certainly fee-only financial advisors have their place and there are managers with the utmost integrity (thinking of people like Rick Ferri), but for many of us…there exists a simple solution to investing…one that is far better than most of the options we have done on our own or been encouraged to do by unethical financial advisors. The key to the solution is something called index investing.
When it comes to investing, an index is a group of stocks or bonds…depending on the index that group could be quite large (as is the case for the Total Stock Market Index) or it could be as small as a Real Estate Index in Brazil for instance. Morningstar divides the US Stock Market into nine style boxes depending on their capital size and value/growth orientation. An active mutual fund manager will typically specialize on one of those style boxes and try to consistently beat the market index. The chart below shows the failure rate of active managers.
In every style box passive index investing consistently beats the majority of active fund managers over the long haul. If you invest in an index fund you still face market risk (markets can go down as well as up), but one risk you are able to avoid is manager risk. Granted, some managers can outperform the market and sometimes for a long time…but there is significant risk that they won’t or that you won’t pick the right one. I had a great fund that I picked up in the late 90’s (the Spectra fund)…unfortunately the manager was in the Twin Towers on 9/11 and consequently I lost my manager at the same time that the market tanked…after that I have diverted more and more of my investments into passive index funds.
|% Underperforming benchmark|
|Median fund excess return|
Source: Vanguard calculations using Morningstar data. Data shown are for the 15 years ending Dec 31, 2010
For simple investing there are only three basic categories of investments that you need to be concerned with when you start out: US Stocks, International Stocks, US Bonds. Fortunately, it is quite easy to find index funds that track those categories. Vanguard, a leader in providing low cost mutual investments, offers a Total Stock Market Index fund (US Stocks), a Total International Index fund (International Stocks) and a Total Bond Market Index fund (US Bonds).
Now a simple approach to investing for someone just starting out might be to invest:
65% in Vanguard’s Total Stock Market Index fund
25% in Vanguard’s Total International Stock Index fund
10% in Vanguard’s Total Bond Market Index fund.
If you want to be more conservative you could take some from the international fund and apply it to the bond fund, but in general that’s a good starting point. The best way to invest simply is to have an automatic monthly payment scheduled. However, each of those categories will likely increase/decrease at different rates, so that by the end of the year your percentages will be different. So, sometime each year you will need to rebalance your portfolio in order to get back to your model asset allocation. Rebalancing is important, but it is also a benefit since it forces you to sell high and buy low.
Now if you want to invest in the truly simplest way, you would invest in one fund that would hold your model allocation and rebalance for you. Amazingly enough, Vanguard (and others of course) have a fund for you…they are called Target Retirement funds. They start out with an allocation similar to the above but then as you get closer to retirement they get more conservative, reducing stocks and buying more bonds and eventually even adding inflation-protected bonds and cash.
You could do far worse then simply investing in a Target Retirement fund and setting up an automatic monthly payment. In fact, the odds are it would be a better choice than anything else you might choose to do.
For more information on indexing in general take a look at this video:
and for information on Vanguard’s Target Retirement fund take a look at this:
I’m not a financial counselor nor do I work for Vanguard, but I do have part of my retirement invested in a Vanguard Target Retirement fund so I do practice what I preach.