How To Invest In A Low-Return Environment

Nobody can predict the future, of course, but it seems likely the days of consistent double-digit returns 80’s and 90’s style are long gone (at least until the next bubble), which leads to a perplexing problem:  how to invest in a low-return environment?  Your financial needs surely haven’t decreased along with the stock market.  On the contrary, if anything they’ve gone up significantly over the past decade.  Growing complacent on the heels of generous stock returns, some fundamental principles of sound investing seem to have been tossed by the way-side.  After all, when everything is going up, long-held principles such as diversification and controlling costs seem quaint and out-dated.

Now that those happy days are gone, we’ve got to get back to the basics of investing.  Fortunately, you can still eke out decent returns by following a few simple principles.

How To Invest In A Low-Return Environment

Save More!
Americans leaned a dangerous lesson over the past few decades which has come crashing down over the past few years.  The idea that you could retire comfortably saving  as little as 4-5% of your income by relying on the market to generate huge returns is dead.  Investors can no longer count on the market bailing them out of poor decisions or misallocations of capital.  If you want to retire comfortably, you’re simply going to have to save more money.  As a general rule, you should aim to save 15% of your income at a minimum.  If the markets somehow manage to churn out double-digit gains in the future, you’ll be pleasantly-surprised by your account balance;  however, you can’t afford to depend on it.  There’s a very good reason most “how to invest” articles list “saving more money” first and foremost:  the more you start with, the more you end with.

Costs Matter Now More Than Ever
An expense ratio of 1% isn’t too bothersome when stocks return 12%, which only amounts to 8.3% of your returns.  It’s an entirely different story, however, when stocks only return 7%.  Why would you give up 14.3% of your return to a mutual fund manager who can’t even beat the market when there are plenty of low-cost index funds costing less than 1/5th of what you’re paying?  The Vanguard Total Stock market Fund (VTSMX) low 0.16% expense ratio means more money in your pocket.  Since very few funds are able to outperform the market over the long term, the wisest course of action is simply to buy the market as cheaply as possible.  0.16% < 1%.

Minimize Taxes
Nobody likes paying taxes no matter how much they make, but when profits are already low, the last thing you want to do is pay Uncle Sam.  Fortunately, there are plenty of ways to minimize your tax liability and keep more of your returns for yourself.  Tax-managed mutual funds, index funds, and municipal bond funds are all relatively tax-efficient investments (click here for the three best mutual funds for your taxable account) whereas actively-managed mutual funds, taxable bonds, and real estate are best avoided outside of tax-advantaged retirement accounts (click here for 401k advice).  As you might have guessed, how you arrange your portfolio based on the tax-implications of various asset classes (called asset location) has a big impact on your account balance over the years.

Stay Diversified
If you can’t maximize returns, you can at least minimize risk.  Making risky investments in an attempt to gain above-average returns is a recipe for disaster.  At the very least, you should own at least 3 basic asset classes in order to be diversified:  domestic stocks, foreign stocks, and domestic bonds.  Ideally, you should own more like 7 or 8 asset classes including real estate, small-cap stocks, and commodities.  Click here for more on modern portfolio theory.  Diversification won’t earn you huge returns, but it will prevent you from losing everything in a crash.  It’s more important to keep what you’ve got than earn more.

Lower Your Expectations
Time to face the truth: you aren’t going to get rich overnight in the market.  Any strategy with high short-term rewards also comes with high short-term risks.  I can only tell you how to invest to maximize your chances of long-term financial security.  Nobody can tell you how to reliably generate large returns in the short term.  If somebody tells you they can, it’s a safe bet they’re a con artist.