Index Investing: A Quickstart Guide
In case it’s not obvious, I am a huge proponent of index investing. I believe the evidence supporting long-term buy-and-hold investing in index funds over actively-managed funds is so persuasive that only a fool would attempt to beat the market with active management, market timing, or any other such investment strategy (perhaps value averaging is an exception, but the jury is still out on that one).
I’m not going to get into the indexing vs active management debate here; check out my archives for my thoughts on the subject, but rather I’m going to give a brief primer in how to get started with index investing.
An Index Investing Primer
Whole books have been written on asset allocation. For an in-depth explanation of the concept, I highly recommend both Rick Ferri’s All About Asset Allocation and William Bernstein’s The Intelligent Asset Allocator. Before you even read the following tips, you should have at least 6 months’ expenses saved up in a high yield money market, savings account, or high yield CD.
Here’s my three-bullet summary of asset allocation concepts:
- Aim to own at least 3 or 4 non-correlating asset classes – Recommended asset classes include domestic stocks, foreign stocks, bonds, real estate, small-cap and value stocks, and commodities. You don’t need to own them all, but you do need to own a minimum of the three most important ones: domestic stocks, foreign stocks, and bonds.
- Buy only index funds – Roughly 80% of actively-managed mutual funds will under-perform their relevant index over the long term. You may think you can pick winners, but the odds are against you. And even if you manage to pick one winner, picking winners in all the different asset classes is going to be nigh-impossible. The chance of picking winners in 4 different asset classes all at once is 0.2 x 0.2 x 0.2 x 0.2 = 0.0016 = 0.16%! Are you that lucky? I doubt it.
- Keep costs down! – Every penny of your investment dollars that go to a portfolio manager, financial advisor, or Uncle Sam is 50 pennies you won’t have in retirement. Why? Because the power of compounding applies just as much to costs as it does to returns. A dollar in expenses paid today is a dollar that won’t turn into 30 dollars in a few decades. Costs matter!
So How Should You Allocate Your Portfolio?
People make this out to be far more complicated than it really is. Here’s all you really need to do:
- Determine your risk tolerance – Are you a conservative investor? Or do you not mind taking prudent risks for the chance at reaping large gains? Your risk tolerance is the single most important behavioral variable when it comes to investing. If you invest too aggressively and another 2008 happens, you may panic and sell out near the bottom of the market, locking in huge losses from which it might take years (or decades) to recover. You should invest according to how much volatility you will be able to take without panicking in a bear market. A common rule of thumb is that your allocation to stocks should be no more than double your maximum tolerable loss in any one year. That is, if you would be willing to tolerate a 40% loss in your portfolio in a bad year, you should invest no more than 80% of your portfolio in stocks. Maximum tolerable loss 20%? Then you should invest no more than 40% of your portfolio in the stock market. When in doubt, always err on the side of conservatism!!!
- Determine how many auxiliary asset classes you want to own – Everybody needs to own at least three asset classes (domestic stocks, foreign stocks, and bonds) but many investors choose to further diversify by owning small-cap value stocks, emerging market stocks, real estate, and even commodities. These auxiliary asset classes are really just icing on the cake in that while they will probably bring a small additional diversification benefit, the lion’s share of the diversification will come from the first three asset classes. Personally, I own all of the above asset classes except commodities (check out my current IRA allocation for more details).
- Be mindful of taxes – In a perfect world, you wouldn’t have to pay attention to taxes because there would be no taxes. Unfortunately, this world is as far from perfect as it could possibly get. The holy grail is to have all your assets in tax-advantaged accounts like a Roth IRA or 401k plan, but that’s a bit unrealistic for most investors. In general, tax-efficient stock index funds belong in taxable accounts and tax-inefficient asset classes such as bonds and REITs belong in tax-advantaged accounts. 99% of investors would be better off ignoring more esoteric accounts such as variable annuities.
- Implement your plan and then resist tinkering! – You could literally spend every hour of every day tinkering with your portfolio if you wanted. Perhaps you think long-term bonds are a better deal than short-term bonds in this interest rate environment or perhaps you heard small-cap emerging market stocks have had a superior risk/return profile to domestic small-cap value stocks over the last 13.496 years. That may be true, but you’ll never get any peace if you’re constantly tinkering with things. The biggest enemy of a good plan is the pursuit of a perfect plan. Come up with a good plan, implement it, and then move on with your life. The point of investing is to secure your financial future. If you spend all your time agonizing over the exact details of your past performance, you’re completely missing the point. Make a conscious decision to look at your balance only once per quarter and then brutally enforce your decision if need be. Better yet, get a dog and take him to the park. It’s nice out (at least in Georgia).