Investing 101: Allocation, My Ass(et)!

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Figuring out an appropriate asset allocation can be one of the most confusing and stressful parts of investing, and its intimidation factor seems to keep many people from investing at all. I’m here to tell you a secret as a new investor: you don’t have to worry this — if the fear of finding the “right” allocation is holding you back from investing, it’s OK to skip this step.

(As I hear the collective gasp from financial advisors everywhere, this is probably an appropriate time to remind you that I am not a certified investment advisor, accountant, financial planner, or anything else of the sort, and the advice I’m giving here is what’s worked for me. It might not work for you — but what I know definitely won’t work is hiding your money under a metaphorical mattress where it has no room to grow.)

There are so many moving factors that can make investing complicated — different accounts (for example, I have a Roth IRA, a 401(k), and a brokerage account); different goals (retirement savings, stable investments to beat inflation with my emergency fund, and making more short-term cash); and a gazillion different investment choices (mutual funds, bonds, individual stocks, ETFs). If this feels paralyzing, that’s normal. But you know what’s even more paralyzing? Letting your money sit in an account where it does nothing except lose value over time due to increasing inflation.

Remember when you were a kid and you scrimped and saved to get $20 in your piggy bank to buy a new GameBoy cartridge? Well, if you’d left that money in your piggy bank, 25 years later it would still be $20. Something, but not much. If you’d invested it, based on the 7.62% average return of the stock market (including inflation!) over the last 25 years, you would have $125.42. Some years it would have gone down in value (some years dramatically, and sometimes for several years in a row), but over time the stock market generally goes up.

ltrUnless something apocalyptic happens in the world, I feel very confident that this upward trend will continue — and if it doesn’t, we will be effed in so many other ways that I am pretty sure my investments will be the least of my worries. (It’s also worth noting that if you’d spent the money to buy TMNT Fall of the Foot Clan instead of saving it, today you’d have approximately … nothing. There’s a frugality lesson in there somewhere, I’m sure.)

ltr2So what’s the best way to mimic the overall returns of the stock market? Buy an index fund that tracks the returns of a large group of stocks, such as an S&P 500 index fund or a total stock market index fund. Vanguard has some great options, both as regular mutual funds and as ETFs, but even if you’re looking at a retirement account that is managed by another brokerage firm, you should be able to find something similar. This, in fact, is Warren Buffett’s advice that he shared in an annual letter to his Berkshire Hathaway shareholders and the instructions he has left in his will:

“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

The key factor I look for in buying any fund is the expense ratio, which is a measure of how expensive the fund is to operate — i.e., the “hidden” fees that will get subtracted from your gains along the way. You won’t notice they’re missing, but your returns will be lower over time. Managed mutual funds have much higher expense ratios than index funds and ETFs. Look for a fund’s list of “fees and expenses” to identify its expense ratio.

One key to this strategy is buy and hold for the long term, making it ideal for retirement accounts. If you know you are going to need to access your money in the short term (i.e., the next few years), be aware that there is a risk it might go down — it pretty much always does, but then, historically speaking, it has always gone back up again. Being patient and staying firm during a downturn is hard, no question, but investors who buy and hold through market swings do better on average than those who try to time the market. Like great rotisserie chicken, just set it and forget it!

Are there more involved asset allocation strategies? Absolutely. There are many philosophies about what works and what doesn’t. In future posts, I’ll cover my strategy in more detail and discuss some other options for those of you who want to dive deeper into some of these questions and may be feeling a little more adventurous. This is just the 101 class, after all!

 

 

© 2015, Cheddar Pie. All rights reserved.

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