Have you ever had to set up one of those complicated plastic toys, the ones with a million pieces that don’t quite fit together and that are always short on washers?
I remember having to set up one of these multicolored monstrosities for our son during the holidays, working late into the night and just barely getting the stickers in place before he sprang from bed to open his presents. (His favorite toy ended up being the pile of wrapping paper and bows we had shoved in the corner. He repeatedly dove into that like a dog in an autumn leaf pile.)
Investing can feel like building those play structures — the instructions are unclear and inconsistent (You wonder, “How much do I save? What should I invest in? What in the world are ESG/IRA/ETF/401(k)/ROI?”), the process feels overwhelming, and you don’t really know how the billion little pieces will amount to something structurally sound.
But don’t let this complexity discourage you from funding your future. Here are five principles for investing.
1. Make A Plan
Investing is akin to a long road trip. Where do you want to go? Defining your investment goals is an important first step. Your goals should go beyond the typical “retire at 65” response, too.
Want to pay down your student loans in ten years? Fund your children’s college tuition before their fifth birthday? Take a month-long Europe trip at retirement? Perfect — you’ve chosen a final destination and have planned some scenic stops along the way.
Once you define your goals, how will you get there? Your ongoing savings and contributions are the fuel to power your trip. Just as you don’t need to fill your trunk with extra tanks of gas for a long drive, you don’t need to fund all of your investment goals in a single day. By defining a budget and prioritizing saving, you will systematically top up your investment tank to get you where you need to go.
OK, so now you’ve saved some money. What do you do with it? Your investment allocation should marry your investment goals with your risk tolerance. And while your allocation should remain relatively static — no one would want to go from 65 mph to 35 mph in a few short seconds — it should adjust over time as you approach your investment goals.
2. Start Early, Save Often, Stay Invested
Getting started is often the hardest part of investing. The easiest place to start is with your employer’s retirement savings plan, such as a 401(k). Most firms offer matching contributions, giving your savings a boost.
If an already established 401(k) is not available to you, then consider traditional IRAs and Roth IRAs. These types of accounts come with some complicated rules, so be careful before contributing.
There are also after-tax options, like brokerage accounts. An ideal goal is to have a healthy mix of pre-tax, tax-exempt, and taxable accounts, though this is an individualized decision. (Hint, we cover this in more detail in the bonus tip at the end of this blog post!)
While it’s a great feeling to invest a large chunk of money, the best way to build wealth in your portfolio is through consistent contributions. Build a budget (or savings plan, if you prefer) and pay your (future) self first by saving a certain percentage of every paycheck. A good savings starting point is 15 percent of gross income, though that should scale up over time. You can even gamify it by slowly increasing your savings rate and seeing if you can still live the same lifestyle.
Finally, the markets will not always gently glide higher, and there will be periods of underperformance. It’s simply the nature of the game. It’s important, though, that you stick to your strategy and stay invested. A quote we use often is “It’s not timing the market, but time in the market, that matters.”
For example, if you fully invested $10,000 in the S&P 500 from January, 4, 1999, to December 31, 2018, you would have ended up with $29,845 for a 5.62 percent annual return. If, however, you managed to miss the 60 best days, that $10,000 investment would have been worth only $2,144 for a -7.41 percent annual return. But how would you miss the 60 best days? Well, six of the market’s ten best days occurred within two weeks of its ten worst days. If the market is volatile and you choose to temporarily get out to “wait for things to calm down,” you will likely leave significant positive returns on the table.
3. Choose Long-Term, Low-Cost, Diversified Investments
According to a Dalbar study, average investor returns over a 20-year period were only 2.6 percent, while a standard 60/40 stock/bond portfolio returned 6.4 percent. Why such a large discrepancy? The study attributes this difference in performance to badly timed — and likely emotionally driven — overtrading. Ignore the short-term agita and let the market work for your long-term goals.
Allowing the markets to work for you over the long-term is important, but so is focusing on the fees you pay to stay invested. In fact, overpaying for your investments is almost as bad as overtrading your investments.
Sales loads and expense ratios are an explicit drag on your long-term performance. Unfortunately, many times, these fees are hidden in the fine print of a fund prospectus. In this case, out of sight isn’t out of mind, and many people mistakenly believe they are investing “for free” when that is anything but the case. Do you know what you are paying for the funds in your 401(k)? If you think the answer is nothing, then I’m sorry to burst your bubble but that’s the wrong answer.
There’s nothing worse than eking out steady gains by appropriately allocating your investments and contributing continually — only to find out decades later that you’ve been giving 1+ percent back every year in expense ratios and sales loads.
According to a NerdWallet analysis, an investor starting with $25,000 and contributing $10,000 over a 40-year career (and assuming 7 percent annual returns) would be $590,000 worse off if he or she paid 1 percent more in fees.
And while we all have that one neighbor or relative with a hot stock tip, being broad and boring is best. A fully diversified portfolio prevents a cataclysmic outcome. Concentrated owners of Enron, Blockbuster, and Lehman Brothers stock can sadly attest to the dangers of going all in on what turned out to be a busted blackjack hand. Over the past 70 years, a 60/40 blend of stocks and bonds has never had a negative return over any rolling five-year period. Broad and boring is indeed best.
4. Ride the Wave of Dividends and Compounding
As stock owners, you are entitled to the profits of the firm that are paid out to shareholders. These dividend payments can offer an enticing supplement to income, but it's best to reinvest them back into the market.
Just how powerful a return tailwind are dividends? The price return — ignoring dividends — on a $10,000 investment into the S&P 500 from 1970 to 2018 was $279,688. Sounds pretty good. But what was the return with dividends fully reinvested? A cool $1,192,011. Reinvesting dividends is an easy, automatic way to increase your contributions into the market, helping boost your savings rate and the opportunity for compounding growth.
Compounding is truly is the secret sauce of investing. If you invest $250 per month at age 25 and earn 8 percent annually, by age 65 you will have $878,570. If you invest $250 per month at age 35 and earn 8 percent annually, by age 65 you will have 375,073. If you invest $250 per month at age 45 and earn 8 percent annually, by age 65 you will have $148,236. Still want to wait one more year to save?
5. Volatility is Normal; Tune Out the Noise
The 2010s were the first decade in American history without a recession. Outside of a few fits and starts in Europe and Asia, the smooth economic growth was what the market needed after an exceptionally tumultuous Great Recession and the lost market decade of the 2000s.
While many investors may be worried about the current market upheaval, volatility is a normal, necessary part of the market experience. Investors contend with a seemingly endless torrent of new economic, political, and technological change. Periods of large market moves — and market underperformance — will invariably happen. For instance, markets experienced double digit declines in 22 of the last 39 years, but they still managed to end in positive territory 75 percent of the time.
The financial news media amplifies the angst and anger of aggressive market moves. Tune this all out. You’ve diligently prepared your portfolio to weather the occasional downdraft and have implemented strategies to take chips off the table when times are rolling. The crisis of the day on the news shouldn’t sway your savings rate or retirement income plan.
Bonus Tip: (Asset) Location, Location, Location
We are now venturing into Investments 201, but two of the biggest drivers of your overall investment performance are asset allocation and asset location. We discussed asset allocation. But what is asset location?
Let’s say you feel comfortable with a 60/40 of broadly diversified, low-cost, and long-term investments. I’m thrilled you agreed with Principle #3. But where will those investment go? More specifically, which types of accounts (and tax treatments) will hold what types of investments?
Putting your investments into the proper vehicle could add anywhere from 0.20 percent to 0.50 percent annually to your return, according to two different studies from Morningstar and the Journal of Financial Planning. And it doesn’t add any additional investment risk! (A quick caveat: Each type of account has different tax treatments and contribution or distribution rules, which can complicate your plan).
The standard approach is to put the most tax-inefficient investments (typically bonds given the income tax treatment of interest payments) into tax-deferred accounts like 401(k)s and IRAs. More tax-efficient investments, like broadly diversified stock index ETFs, should be slotted into the taxable accounts. And high-risk/high-return assets round out the tax-exempt accounts, like the Roth IRA.
This is a good rule of thumb, but it’s also important to note that this is a highly individualized decision, with other considerations outside of just tax treatment. For instance, putting highly appreciating equities into an IRA may be a better choice in some cases, so you can take advantage of the tax-deferred compounding over decades versus the continuous tax drag in a brokerage account. On the flip side, though, you would then lose the step-up in basis if the equities were in an IRA versus a taxable account.
Sometimes the choice is made for you. For example, if you have 90 percent of your investable assets in tax-deferred accounts, you can only optimize so much given the account concentration of your assets.
Despite this added layer of investment complexity, spending a little time up front and directing your incoming saving streams into the right bucket can provide a “free” boost to your returns over time.
Investment Management with Harbor Crest Wealth Advisors
Investing for your future doesn’t need to be overly complicated. By following the principles laid out in this article, you are well on your way to achieving all you want and need out of the market. If you would like some help getting started and building your plan, give our free tools a try.