How to Invest – It’s Easy

It’s really just two steps:

1. figure out your asset allocation, then
2. buy index funds to fill in your asset allocation

1. Asset allocation is considered the most important determinant of your long-term investment returns. It basically defines what percentage you put in stocks vs. bonds. Generally, the younger you are the more in stocks you should have. As you grow older, more of the mix should be moving towards bonds. And when you’re ready for retirement, when you have to depend on your investments for income, the majority of your portfolio should be in bonds. So how do you determine your mix? It’s simple arithmetic and depends on whether you can take the ups and downs (and believe me, there are plenty of them) in the market without panicking and selling at the bottom (which would be considered a dumb move).

So if you don’t think your blood pressure can hand market swings, then, conservatively, your bond position percentage should equal your age, with the balance in stocks. So if you’re 30 years old, you should have 30% in bonds and 70% in stocks. Or in other words…

Conservative percentage in stocks = (100 – your age).

If you can handle ride through the swings in the market, and can stand some of the stomach-wrenching ups and downs, then more aggressively

Aggressive percentage in stocks = (120 – your age).

So that adventuresome 30 year-old may have 10% bonds and 90% stocks.

Of course, do not invest money that you will need within the next 5 years. So if you’re planning on buying a house or car, it’s best to store that money in investments whose prices don’t fluctuate wildly, like CD’s or money markets.

2. Index funds- Now that you’ve determined your asset allocation, index funds are the only investments you should consider buying – whether they’re stock index funds or bond index funds. Don’t take my word for it, consider what Warren Buffet said:

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals”

There are too many studies to cite that have shown that index funds outperform the vast majority of actively managed funds. For more details, see my blogs on “Index Funds” for an depth analysis on why actively managed funds rarely overcome the fees, sales loads and expenses involved in acquiring them.

So what should your investment portfolio look like? The best way to explain this is through an example.

Say you’re a 35 year-old woman who already has an emergency fund set aside and is ready to invest with the rest of her money. You’re not in a high tax bracket, and you’re on the aggressive side and can stand watching the market go up AND down without panicking and selling at the bottom. Here’s an example of what your portfolio can look like:

• 85% stocks
  • 50% Vanguard Total Market Index Fund
  • 25% Vanguard Total International Stock Market Index Fund
  • 10% Vanguard Small Cap Index Fund
• 15% Bonds
  • 15% Vanguard Total Bond Market Index Fund

Now I know what you’re thinking: there’s an awful lot of “Vanguard Funds” in this account. Well, hear me out, Vanguard is a not-for-profit mutual fund company. This means that investors are shareholders. So Vanguard’s interests will always be aligned with my interests and those of its investors. Compare this to the majority of fund companies who are just in the game to make money for themselves.

Companies such as American Funds or Franklin, in contrast, are for-profit companies. Their cost-cutting tactics and profits accrue to the companies themselves. Their products are nothing more than more expensive actively-managed funds, mostly sold to investors who don’t do their homework…

Who would you rather invest alongside with, a company whose interests are aligned with yours or a company whose only interest is making money for itself?

Personally, I’m invested in the Vanguard Small Cap Index, Total Market Index and Total International Stock Market Index. That’s how I know so much about these funds.