Investing Strategy

investing strategyWhile I follow the Dave Ramsey “baby step” plan to get towards financial freedom, Dave consistently quotes 12% as an expected long term rate of return for stock mutual funds. While I agree that an investing strategy focusing on stock mutual funds over the long term is the way to go, 12% returns are very optimistic. Although the stock market as a whole has fared this well in the past, past performance is no indication of future results. So while I have similar suggestions as Dave Ramsey as to what to invest in, I do not estimate returns as great. For all of my calculations I assume an 8% annualized return over the long run, I think this is quite conservative, but since the future is uncertain I would rather err on the side of caution when deciding how much to save. By running the numbers in an investing calculator you can see how big a difference it is. If you have 30 years to save for retirement and want to have $1 million at that point in time, at 12% you would only have to save $310 per month, while at 8% $685 per month would be needed to be saved. I would rather over save then under save when dealing with the unknown rate of return. If I happened to get 12% annualized returns I would just be happy to have close to twice as much as I needed.

 

But what stock mutual funds? There are thousands! Another spot where I differ from the Dave Ramsey school of thought is that I favor index funds (passively managed) vs. actively managed funds. Passively managed funds, or index funds seek to represent an entire market sector. Actively managed funds seek to pick winners and losers and invest accordingly. Actively managed funds thus come with more costs due to increased trading, and paying someone to make the decisions on what to buy, what to sell and when to do so. Index funds outperform Actively managed funds an astonishing 82-90% of the time, and do so with less risk!

 

Once you’ve made the decision to go with index funds, deciding which funds to go with becomes easier. To start out with I would suggest the Vanguard Total Stock Market Index Fund (VTSMX). This is offered in many company 401Ks and has an extremely low expense ratio. This gives instant diversification, but has a downside. Since the stock market as a whole includes more Large cap stocks, small and mid cap stocks are under-weighted in this fund. I would suggest adding a small cap index fund and an international fund to your portfolio. By including index funds from different sectors you lower overall risk and can increase returns. Why Vanguard? Vanguard has lower expense ratios for its index funds than virtually all of its competitors. Lower expenses equals greater returns.

 

What I recommend against:

 

Buying individual stocks: When people refer to investing in the stock market as gambling, this is what they are referring to. Buying individual stocks is extremely risky because one lawsuit, one bad quarter, one bad CEO, one bad incident can bankrupt that company. $10,000 in Enron stock became worthless overnight, while even though Enron was included in the Vanguard Total Stock Market Index Fund, $10,000 of that was worth roughly $10,000 the next day because the percentage in each company is so small. I would not invest retirement funds or college funds in individual stocks.  I think individual stocks can be used as part of an overall portfolio, but it has to be money you can afford to lose.

 

Currency Markets: Buying and selling currency and commodities are also a gamble. Many currency markets also allow you to trade on margin, which can result in you loosing more money than you put in.

 

Bonds: There are several reasons why I do not own bonds or recommend bonds in a portfolio: Bonds return a far lower rate than stocks over the long run. Due to the unprecedented “quantitative easing” policy of the federal reserve, bonds are at a long term artificial low. The yields are simply not enough to earn any real return on. Bonds make sense for those who are actually retired, but even then the conventional wisdom of 100-your age is the percent of bonds you should own is crazy. Dividend paying stock funds while also generate income will continuing to increase in value. If you do decide to invest in bonds, just like with stocks, do not buy individually, buy into a bond fund to lower your overall risk.

 

Insurance: Insurance should be insurance and investments should be investments. Whole Life, Universal life, Gerber grow up plan, etc… are all essentially scams. The only people who recommend these products are those who are selling them and earn a fat commission in doing so.

 

Market timing: Market timing does not work. No one is smart enough to know exactly when a stock or class of stocks will go up or down. Those who practice market timing will loose money. Investing every week, every month, every year in the same index funds is the only way to go. I wrote about this in a previous article about Dollar Cost Averaging. It is necessary to separate emotion from these transactions, otherwise you will force yourself to sell when your investments take a tumble, and buy more when they are up, the exact opposite of what you should be doing. “Bears and Bulls both make money, but pigs get slaughtered.”

 

What I do:

I will not discuss the amounts I put in, but I will say that my wife and I invest over 20% of our income. All of our investments are in tax protected accounts. First we fund her 401K to receive the maximum match, then we fund our HSA to the maximum and then we invest a mix between our traditional and Roth IRAs. Between our 6 accounts we are invested in the following funds:

 

Vanguard Total Stock Market Index

Vanguard Small Cap Index

Vanguard Mid Cap Index

Vanguard International Explorer

and Vanguard REIT index

We have the money automatically transferred and invested every week. All we have to do is make sure we have money in the bank account to cover the transfers.

Many of these funds require $3K to $10K to get into, but Vanguard offers most of them as ETFs, which allows you to start investing with a much lower amount, several are less than $100 a share. ETFs are essentially mutual funds that are traded like stocks. HSAAdministrators, the company we have our HSA though allows first dollar investing into these funds, so that’s one more way to avoid the minimums.

This covers what I would suggest for all available funds up to the maximum you can put in tax sheltered accounts.  Once 401Ks, IRAs and an HSA are maxed (The total amounts will be different depending on your situation) Then I would put any extra money towards paying off the house. I recently paid an extra $5,000 on my house which took years off my mortgage.

 

What is Your Investing Strategy?

John C. started Action Economics in 2013 as a way to gain more knowledge on personal financial planning and to share that knowledge with others. Action Economics focuses on paying off the house, reducing taxes, and building wealth. John uses the free tool Personal Capital to track his net worth and posts quarterly updates on his finances. Check out the Action Economics archives section for all past posts.

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