The next step on our journey into investing and economics should be obvious at this point:
What should we be investing in?
People Suck at Investing
There’s a simple fact that can feel overwhelming when we first learn about investing: people suck at it.
Even the pros aren’t very good. These are people that spend all day studying how to beat the market, and two thirds of them still fail in any given year. Even worse? The fact that most of the third that succeeds appears to do it by luck, as only 10% beat the market over a 15-year period.
Individual investors are even worse. And, like the pros, the longer the timeline, the worse the under-performance.
So what chance do we really have to succeed in the stock market?
Where Everyone Else Goes Wrong
The key to good investing is understanding where everyone else goes wrong.
When it comes to individual investors, the biggest problems are investor behavior and fees.
“Investor behavior” sounds like a huge hurdle to overcome, but there are some simple tricks you can use to avoid the biggest issues.
First, don’t time the market. You’re up against people that are spending all day every day trying to find clues as to how to time the market. You won’t do it better than them. Stop trying.
Relatedly, don’t trade often. The market goes up in the long term, so buy and hold for as long as you can. There will be ups and downs, but the market has always eventually gone back up.
Finally, don’t try to beat the market. Even the pros suck at that. Just buy as much of the market as possible and ride it out.
Luckily, the best way to buy the market is also the best way to lower your fees.
The answer to both of these problems is broad, market-based index funds.
Index funds are baskets of stock that are put together to move in tandem with a specific index. For example, the Vanguard Total Stock Market Index Fund is designed to match the movements of the U.S. stock market. The Vanguard 500 Index matches the S&P 500.
Know Your Options
Your access to some of these funds may differ based on the accounts that you have.
As we discussed previously, employer-based accounts often will have a limited selection of funds to choose from. On top of this, accounts that you open yourself will generally have lower fees for whatever funds that broker has put together. If your account is with Vanguard, then it is cheaper to buy Vanguard funds. If your account is with Schwab, then it is cheaper to buy Schwab funds.
Find the best options available to you of broad, low-fee index funds and go for it.
Regardless of your familiarity with investing, you are probably familiar with the idea of (or at least the term) asset allocation.
This is where you create a target mix of different wealth-building tools in your portfolio and work to maintain a set percentage of each. Maybe you want 80% stocks and 20% bonds. Maybe you want 30% U.S. stock, 30% international stock, 30% U.S. bonds, and 10% cash.
The level of detail can vary, but the general concept of maintaining an asset allocation is useful for multiple reasons.
Buy Low and Sell High
First, when done intelligently, a good asset allocation can lead you to better returns.
It can force you to buy low and sell high.
Let’s say you want to have 50% stocks and 50% bonds. If stock prices are rising rapidly and bonds are not, then soon you’ll find that your portfolio consists of 55% stocks and 45% bonds simply because stocks have grown faster than bonds. You then sell stocks that have performed well and buy bonds that have not to get back to a 50/50 portfolio. This is called rebalancing.
Without having that target allocation to fall back on, it is very hard for us to buy low and sell high. Our instinct is to ride the hot hand. There’s a party in the markets and we don’t want to leave early.
Similarly, nobody wants to buy a loser. It is hard to remind ourselves that these things are cyclical and that the losers and winners are going to flip sometime soon. A target asset allocation takes these decisions out of the realm of emotions and into the world of cold hard numbers.
The target asset allocation also helps us stick to our strategy when markets get crazy. If the stock market falls 50%, it’ll be really easy to convince yourself that it could fall further and you should get out. That this time is different. That everything is collapsing.
A target allocation allows you to remove emotion from the equation again. You’ve got your numbers and as long as you keep to them you’ll be fine in the end.
It helps you stick to your strategy.
Combining Index Funds
Even sticking to index funds, you can still get a mix of different assets in your portfolio and can figure out a combination that works for you.
Maybe you want a U.S. index, an international index, and a bond index. Maybe you want to break down the international stocks into an emerging markets index and an OECD index. Maybe you want some other breakdown entirely.
I won’t give you advice on this, because I don’t do it.
I don’t have a target asset allocation.
100% of the money in my 457(b) is in the Vanguard Target Retirement 2050 Fund (VFIFX).
100% of the money in my IRA and my taxable account is in the Vanguard Total Stock Market Index Fund (VTSAX).
100% of the money in my HSA is in the Schwab Total Stock Market Index Fund (SWTSX).
I chose my funds based on the available options in each of my accounts, and I am happy with this balance.
I am comfortable with this approach for a few reasons. One of those is that I have a long investment timeline.
I don’t need the money that I have invested any time soon. I’ve got a well-paying (and secure) job. I’m in a two income household. We have a significant emergency fund at the ready. I don’t need to touch my investments for the foreseeable future.
On top of that, I keep adding to my investments regularly. By throwing more money into the accounts consistently, I am buying every dip in the market. When the market is up, my set contribution buys fewer shares. When the market is down, it buys more.
This may not be the mathematically optimal approach, but it is good enough and requires no time commitment on my part for research or management.
And right now, time is my most prized asset.
Join the Conversation!
What do you invest in? What’s your asset allocation? How did you decide your strategy? Let us know in the comments!