The Amateur Financier

So far this week, we’ve covered a variety of ways to invest, from target date funds to actively managed mutual funds.  But through all these methods, you may have noticed one common trait: you haven’t been completely in control.  You’ve been relying on indexes or professional investors to choose your investments for you.  But what if you, like Delilah, want to take the reins on your own finances?

“I LOVE investing!  I like to do research, educate myself, and study financial literature.  But it seems like so many places just want me to invest in mutual funds, and index funds at that.  What can I do to take control of my investing?”

Well, Delilah, you’re in luck, because today is all about do it yourself style investments.  Let’s start with most commonly cited type of individual investment…

Stocks

Before we get started with investing in individual stocks, let’s go through the standard warning: stocks are risky.  Unlike mutual funds that invest in tens, hundreds, or even thousands of companies, stock from a particular company is tied to the good (or bad) fortunes of that company.  Even if the industry as a whole is doing well, even if the economy is doing fine, problems with the company could cause it to go bankrupt, leaving your stock worthless.

As a result, when investing in individual stocks, you’ll need to keep a few things in mind when stock investing.  First, diversification is a must; no matter how much you believe in a particular company, putting all your eggs in their basket is just foolish.  Be willing to invest in several companies (five to ten, at minimum) to ensure that problems in one aren’t enough to completely sink your fortunes.  Second, be willing to do plenty of research if you are holding individual stocks.  No less an authority than Jim Cramer recommends one hour per stock per week; if you can’t (or won’t) devote that much time to researching your holdings, it’s better to stick with mutual funds in your portfolio.  Third, chances are that you won’t be able to get stocks to fill your entire portfolio; even if you can find enough domestic stocks to fill your needs, there are still foreign holdings to consider (to say nothing of bonds).  Even if you invest in individual stocks, keeping some mutual funds in your portfolio to fill the holes is a good idea.

Alright, enough of the warnings and cautions.  The most common way to invest in stocks (rather than trading, which falls more into the realm of speculation) is to buy in small amounts regularly, slowly building up your holdings.  This is the standard ‘buy and hold’ approach, where you buy a stock with the intention of holding it, potentially forever.  In this approach, be sure to carefully research the stock.  There are plenty of resources available to you to research potential stocks in which to invest (did I mention my fondness for Morningstar yet?).  Be sure to adjust your asset allocation to reflect the added stocks (you don’t want to be overweighed in a particular area should a bubble burst on you).

Follow these tips, and you should be able to add individual stocks to your asset allocation without a problem.  Good luck, and rock on would-be investor!

• So, where do you keep YOUR money?
• What Can John Wooden Teach us about Stock Analysis?
• Friday Fiscals: Flush valve edition
• How Do Bond Mutual Funds Work?
• Building Wealth When the Economy is Slow

So far this week, we’ve stayed pretty passive with our investment strategies.  Yesterday, we covered the basics of creating a portfolio from index funds and the day before, we covered an even easier method, using target date funds.  But what if you, like our (fictional) friend Charlie, want to try to beat the market?

“I’ve had good luck with index funds, but I’d like to try to beat the market.  Unfortunately, I don’t have the time I’d need to do research and successfully pick individual stocks.  How can I put my stock picking desires to the test without having to, well, pick stocks?”

Before we get into some ways to put your market-walloping desires into practice, let’s get through the standard warning: attempting to beat the market frequently fails.  One advantage of index funds is that you’ll always match the index’s performance (minus the relatively small expenses associated with the fund); while the techniques below might be able to beat the market, there’s no assurances that they will.  Consider the possibility for under-performance, if not outright losses, when trying to beat an index fund.  On that cheery note, one method of beating the index is…

Actively Managed Funds

The bulk of mutual funds fall into the category of actively managed, that is, funds that have a person (or much more likely, a team of people, with plenty of support staff) choosing which investments in which the fund will invest.  Besides increased diversity in your investment options, actively managed funds offer you the opportunity to beat the market, which is one of the biggest reasons that they continue to be a major investment options along with the cheaper index funds.

Choosing an actively managed fund is significantly more involved than choosing an index fund.  For the latter, you simply need to create your desired asset allocation, find the appropriate index funds, and fill your portfolio.  Actively managed funds are more complex; you’ll need to not only find an appropriate fund for your allocation, but also make sure that the fund will beat (or at least match) the performance of a comparable index fund.  There are plenty of sources to check when trying to find high quality actively managed funds; one worth checking out for some good suggestions is Kiplinger’s 25, a decent list of professionally reviewed funds to start your search.

When trying to choose a good actively managed fund, your primary concern should be to ensure that the manager is well seasoned and has the skills needed to outperform the market.  When researching the fund, there are plenty of resources to consider; one of the best is Morningstar, which can provide you with all the information you need for less than twenty dollars a month.  (It also has a pretty decent collection of tools and information available for free, just in case.)  If the manager has been outperforming the market consistently for an extended period of time (five to ten years, at minimum), that’s a good sign that they might (emphasis on MIGHT) be able to outperform the market in the future.

The Bottom Line

When investing in actively managed funds, you can potentially beat index and target-date funds.  This potential to beat the markets comes with the need to do lots of research, though.  While you just let index funds go, investing regularly without paying too much attention to how well they are performing (they’re going to mirror the index, after all), actively managed funds require that pay attention to the performance of the fund, the changing of the management staff, and whether the fund is drifting away from the stated portfolio goals. While index funds can be monitored quarterly, even annually, actively managed funds will need to checked regularly (at least monthly, preferably weekly) to ensure that they are still outperforming the index.  If you’re not beating the market with your fund, why pay a premium above an index fund, after all?

• How To Determine Mutual Fund Holdings With Morningstar
• When Are Your Funds Average Returns Good Enough?
• Back to Basics and Mutual Fund Survivorship Bias
• Investment Mistakes in a Bear Market
• How to Get Actively Managed Funds for Free

Yesterday, we covered just about the simplest method for investing you could have, putting your money into target date funds. But it’s a fairly hands off investment; used properly, you’ll hold the target date fund (and only the target date fund) until you reach your target date. What if you, like our fictional investor Becky, want something a little more involved?

“While I like the idea of a target date fund, it’s not quite for me. I need to be able to control my investments, and target date funds just don’t let me do that. Plus, I don’t like the particular arrangement of investments offered in the target-date funds I’ve seen. Where do I go for something that isn’t too complex, but gives me more control?”

Well, if you are trying to be more involved with your investments, but don’t want to do a lot of ’stat-tending’* to make sure your investments keep doing well, there’s one phrase you need to remember:

Index Funds

Index funds are inexpensive, well-diversified, and passive.  Since they are designed to hold absolutely every stock, bond or other investment in a particular index, there’s no worry that you will do better or worse than that index.  You can decide on your allocation, buy the index funds and sit back until it’s time to change your allocation.

If you want a guide to how to use index funds to build an investment portfolio, well, you’ve come to right place.  Here’s a simple, but still pretty effective, way to invest for retirement with index funds:

1) When you have a long period of time (over twenty years) before you’re ready to retire, you’re going to want your investments to entirely in stocks or other growth investments.  Stock mutual funds should be split between domestic and foreign funds, although the ratio will vary depending on who you ask.  Something like 60% Total US Stock Market and 40% Total Foreign Stock should work for most people, although shifting 10% either way wouldn’t hurt.

2) With twenty years to go, you should start adding bonds to your portfolio.  Switch 10% of your portfolio over to a Total Bond Market fund (keeping the proportions of the stocks in the rest of your portfolio the same).  Every five years, at fifteen years to go and ten years to go, add an additional 10% bonds to your portfolio, so with ten years to go, you’ll have 30% bonds, 42% US stocks, and 28% foreign stocks.

3) At five years to go, add 10% cash (in the form of a money market fund) to the portfolio, taking from the stock portion of the portfolio, giving you a final portfolio of 10% cash, 30% bonds, 36% US stocks and 24% foreign stocks.  Not a bad portfolio to take into retirement.

Once again, this is just one possible way to use index funds to build your portfolio; even if you rely on just these few funds, there are numerous other progressions you could follow, with varying advantages and disadvantages.

Additional Types of Funds

As mentioned, this investment plan only uses a few types of different funds.  There are other types of mutual funds, of course, even amongst index funds.  (Depending on what mutual fund company you are investing through, you might need to opt for an actively managed fund or switch to a different fund company entirely to get all the types of funds listed below.)  Here are five to keep in mind as you are building your portfolio:

-Extended Market: Way back when, I wrote about the Pareto problem, where a fund that covers a total market will be over-weighted in the biggest companies.  You can avoid this problem by switching some of your US market holdings to an extended market fund, which will help to diversify your holdings more properly.

-Emerging Market: Pareto again; a total foreign fund will be weighed more towards developed countries.  Getting a separate fund that invests entirely in the emerging market will help to make your foreign holdings more balanced.

-(Small) Value Funds: In that same long ago post, I shared my belief that value-oriented funds will turn out to be a better investment in the long run.  Small value funds in particular will tend to outperform in the future, and are worth adding to your portfolio.

-Foreign Bonds: On the bond side of the equation, you could consider adding some foreign bonds to your holdings.  Diversification is usually a good thing, and doing so in your bond holdings is a good thing.

-Treasury Inflation Protected Securities (TIPS): One good way to protect against inflation is with a relatively recent offering from the US government, Treasury bills that adjust to compensate for inflation.  Switching some of your bond holdings to a TIPS fund will enable you to hedge against a great increase in inflation.

-Tax-Exempt Bond/Money Market Funds: Municipal bonds and money market funds are exempt from federal income taxes (and usually state and local taxes, if purchased by someone within the issuing states).  If you are in a high income tax bracket, keeping some of your bond and money market investments in tax-exempt holdings (for the investments outside of retirement accounts, of course) can reduce how much is taken in taxes.

Alright, that’s enough of how to build your own portfolio from index funds; if you want even more control over your investments, you’ll have to tune in tomorrow, when we’ll cover some more advanced investments.

• Money Market Funds Explained
• Four Important Metrics To Compare Index Funds
• The Four Best Actively Managed Mutual Funds With Low Expense Ratios
• Low Risk Commodity Investing for Inflation Protection
• My Year End Financial Performance Review

So, you think you’re ready to invest.  You have a predictable, if not necessarily steady source of income (from a job, small business, sales commissions, or the like), you’ve paid off any high interest debt, and you’ve built up an emergency fund.  You’re fully covered by insurance for your house, your car, your business (if needed), and even your life, assuming you have any dependents.  You’re ready and raring to go to start to putting your money to work.

Well, you’ve come to right place.  All this week, I’m going to cover a variety different techniques for investing, ranging from the simple techniques for those who have no interest in learning about investing to more complex and involved possibilities for anyone who really gets a kick out of managing their money.  No method is necessarily better than the others; it’s all a matter of personal taste.

For each method, I’m also going to introduce a fictional investor whose attitude is typical of someone who should try that method.  Let’s start with Adam, who is very interested in retirement, but not so interested in investing:

“Yeah, I keep hearing about how pensions are a thing of the past, and how I need to invest in order to retire eventually.  But man, does that sound boring.  How can I make sure I retire on time, if not early, without having to spend all my time reading The Wall Street Journal and watching CNBC?”

First, it’s worth reminding Adam (and everyone currently reading this entry) that there’s no direct link between consuming lots of financial media and having your investments perform well.  In fact, if you end up buying and selling more as a result of said media exposure, you’ll likely underperform, as a result of increased expenses if nothing else.  But back to Adam’s main question; if you want an investment that will require virtually none of your time, there’s one phrase to remember:

Target-Date Funds

A target date fund, for those of you who didn’t catch my Investing 101 coverage, is a fund of funds, a mutual fund that invests in other mutual funds.  The target date fund is designed to start out agressive, holding mostly stock mutual funds and other high-risk, high return investments.  As time passes and it gets closer to the date specified by the fund (the ‘Target Date’ in the title), the fund will shift to hold more conservative, safer investments, until the target date is reached and the fund either (a) cashes out, or (b) converts into a fund designed to provide income, depending on the particular type of target date fund.

There are a variety of target date funds, each covering a different need.  There are retirement funds, where you choose the date closest to the year you hope to retire as your target date.  There are college savings funds, which work in the same way, only using the year that you (or more likely, your children) head off to college as the target.   Finally, there are any number of shorter term target date funds, designed to meet goals like saving for house or starting a business that are so big and costly that you’ll need years to reach them, and don’t want to be stuck getting only a tiny bit of interest from a bank account.

While target date funds aren’t quite ’set it ant forget it’, they come pretty close; they are well diversified, simple, and work very well as the only investment in your portfolio.   Choose one that will meet your target date from a high quality fund family like Vanguard, don’t panic if it goes down in value (target date funds, like all investments that offer a significant return, also have the potential to drop significantly in value over the short term), and as long as you put enough money into the fund at the start or in regular amounts over time, you should be able to meet your goal.  Which brings us to one other consideration for investing…

How Much To Invest

You’ll need to make sure that your investment amounts are on track to reach your goal.  Depending on your time frame, as well as what goal you are trying to reach, you’ll have to invest different amounts.  To help you figure out how much you will need to invest, you can consult with the following chart:

This chart shows what amounts you need to invest to reach $1000 after the given number of years, whether you start with one lump sum, a yearly investment, or monthly contributions.  Why $1000?  Well, it’s an easy amount to multiply in order to reach your desired goal.  If you think you need one million dollars to fund your retirement in twenty-five years, you can multiply by one thousand to find you’ll need $184,250 as a lump sum, $6990 yearly, or $580 each month.  Pretty simple, right?

You should be able to use the table to figure out how much to invest for any goal, but if you’re trying to figure out what to add to your 401(k), it might be easier to have a specific percentage of your income to add.  So, if you are starting with nothing in retirement savings, here are some conservative percentages to put into your 401(k); add these amounts, and you should be able to retire at 65 with twenty times your final salary (enough to withdraw 80% of your final salary each year):

Good luck with your investments, and tune in tomorrow if you’re looking for a more involved investment method!

• Target Date Funds: Not One Size Fits All
• How Much Time Should You Spend On Your Portfolio?
• Why Your 401K is Important
• Guide to Investing Money & Money Management
• Forecasting Retirement Income Success