Investment Strategies: The Diversified Portfolio

If there was a class called Toddlers 101, lesson number one would be called Choices: Which One Would You Rather Have?“Judy, do you want to wear the red shirt or the blue shirt?” In addition to being empowered to make hard choices, the kiddo figures out that wearing two shirts at the same time is not really an option.In the investing classes I teach, we spend a lot of time talking about the hard choices that investors must make. Do you want growth, or do you want safety?The truth is, there’s no magic investing strategy that delivers high growth and no downside.It’s a package deal: If you want high growth, you’ll need to take more risk. If your top priority is not losing money, you can’t expect big gains from your investments.The trick for most investors is to strategically balance growth and risk over the long term.

Diversification Strategy: Balancing Risk vs. Expected Return

The following graph shows data from 1970-2016 on the seven major asset classes, each marked by a black diamond. The vertical axis shows the long-term returns for each asset class (“Compound Annual Returns”) and the horizontal axis shows the degree of volatility/risk (“Standard Deviation of Annual Returns”).  From 1970-1946, the highest average annual returns came from commercial real estate (11.4%), small US stocks (11%), large US stocks (10.3%) and non-US stocks (8.7%).However, those high returns came with a big dose of risk and volatility. The high return assets are clustered on the right side of the graph, meaning that while the average returns over 46 years were high, the yearly returns bounced around a lot. There were big gains in some years and big losses in others.In the bottom left corner we have our turtles, slow and steady. US bonds and cash may not have been the biggest returners over this period, but they were more predictable.Every investor wants to be in the “golden corner,” up and to the left. High returns, low risk. But as you can see, that corner is empty.The red diamond shows a good balance for most investors: a diversified portfolio that uses low-risk assets for stability and higher-risk assets for growth. The red diamond is a hypothetical portfolio where the seven asset classes each make up 14% of the portfolio. Thanks to Modern Portfolio Theory, this equally-weighted portfolio was able to deliver most of the growth of the highest returning asset classes, but with a lot less risk.

Timing: Dial-Down Risk as Retirement Approaches

Just as important as a general diversification strategy is how you manage that balance of high- and low-risk assets over time. If you’re invested in stocks when the market declines, the last thing you want to do is sell while stocks are way down.Keep in mind that starting in 2007, the stock market fell by over 50% and it took 64 months to get back to where it started. That’s almost five and a half years. A good planning exercise is to think about money you might need in the next five years (60 months of living expenses if you’re retired, college tuition for older kids, a down payment on a house) and DON’T invest that money in the stock market.If you have 10+ years before you might need to withdraw the money, then that portion of your portfolio is a great candidate for growth assets like stocks (investing sooner rather than later is almost always the best choice.) 

Being Too Conservative Can Be Risky: Targeting a Higher Rate of Return

Last month we got into the numbers and formulas of Time Value of Money, and you know I love that stuff. But sometimes the math can over-complicate a subject that is actually pretty simple.There are two paths that lead to accumulating enough money to retire comfortably. The first path is: You save a lot of money each year, do that for a long time, and watch your savings pile up. If you save $100,000 per year for 30 years and put it under your mattress, you’ll have $3M saved up for retirement.But for many families, saving that much money each year is not in the cards. The second path -- the one that most people need to take -- is an approach that requires disciplined saving, aggressive investing and strategic planning.The problem people run into is when they don’t save enough each year and they adopt a low rate-of-return investing strategy (think bonds). It seems “low-risk” because they’re avoiding risking the money they have. But in another sense it’s very risky, because it jeopardizes their ability to retire.

Targeting a Higher Rate of Return

Let’s look at three scenarios. They each involve saving $25k per year. The only difference is your expected rate of return over a 30-year time horizon.If you can’t save $100k per year, you can still get to $3M in 30 years with a more aggressive portfolio. (The exact target rate of return to get to $3M by saving $25k per year is 8.3%, FYI.)Of course, in the real world, you can’t lock in a specific rate of return for 30 years unless you stick to super low-risk investments like bonds or CDs, which usually top out around 2-3% per year. To get closer to that 8-10% rate of return, you’ll need to invest in riskier assets, like stocks.Different paths, to be sure, but similar outcomes. The choice is yours as to whether you want to do more of the work by saving, or whether you want your investments to do more of the work by growing.

Takeaway:

To have enough for retirement, you either need to:

Save a ton of money, -or- Invest more aggressively.

We’ll talk more about risk next month, including a strategy that may be able to reduce some of the risks inherent in stock investing.

When to Buy Stocks? Time Value of Money Can Help

My oldest daughter started kindergarten last week, and now I finally get it - time really does go by too fast. What happened to my baby? How can she be old enough to march off to school without even kissing her mom goodbye?When it comes to watching kids grow up, time can feel like your enemy. Fortunately, when it comes to investing, time can be your best friend.Last month I wrote about how a basic stock ETF is a simple way to start investing. This month I’m writing about why it’s so important to start saving and investing ASAP.I watch a lot of people get hung up on trying to “time the market”. After all, the golden rule of investing is Buy Low and Sell High. Don’t get me wrong, this is a good rule of thumb. But it can be an obstacle for investors who interpret it as: “Wait to buy stocks until they hit their lowest possible price, and then sell them when they hit their highest possible price.”Investors looking for a home-run will wait and wait for that perfect pitch. Is the market low enough for me to buy? Not quite yet… But while they’re waiting, time is going by. And that time is valuable. How valuable?

Time Value of Money

Time Value of Money (TVM) is the elegant financial concept that puts a dollar amount on your time. It can also help explain why the phrase Buy Low and Sell High might not always be as beneficial as Buy Sooner and Sell Later. Check it out:We see that, if you start with $10,000, invest it for 5 years, and earn an 8.5% rate of return, you end up with $15,037. Not bad at all.But look how that growth snowballs if you leave the money invested even longer:Thanks to TVM, there is a huge difference between investing for 25 years vs. 30 years -- $38,715 in this case. The effects are even greater after 30 years. From this perspective, the best time to start investing is simply a long time before you need the money.Trying to time the market means waiting for the market to dip so you can Buy Low. But if you're waiting and the market keeps going up, you’ll have missed out on gains you would have had if you’d chosen to Buy Sooner in the first place.Whether you define Buying Low as waiting for the market to experience a 10% dip, a 20% fall, or a 50% crash, just keep in mind that any of those scenarios could happen tomorrow, or they might not happen for a long time. The stock market has not fallen by 20% since summer 2011. Anyone who’s been waiting for a big decline like that to Buy Low has waited 6 years while the market has marched up, up, up.So, if you’re convinced, and if you’re ready to start your 30-year clock today, here are my three easy steps to start investing:

1. Set aside some money and think of it like a “time capsule” - not to be touched for a long time.
2. Buy one or two broadly diversified stock funds.
3. Hang in there for a generation or so without trying to time anything.

Thirty years from now, you may consider time to be the best friend you ever had.  

What is an ETF? The Simple Way to Get into Stocks

I talk to a lot of folks who are just beginning to learn about investing. One thing I notice is how many people wait to start investing because they’re worried about doing it wrong.People get bogged down with questions that professional market analysts have difficulty answering: What stocks should I buy? When is the best time to buy them? How do I find the next big thing? What if I buy a stock today and the company tanks tomorrow? What about Trump?With no easy answers to these questions, some would-be investors sit on the sidelines indefinitely, missing out on the opportunity to grow their wealth. If that sounds like you, here's a tip that might get you over the hump and into the markets.If you're willing to give up the dream of making an 8,000% return on your money by finding "the next Amazon", and if you can leave your money in this investment for the long term (15+ years), you can minimize your risk and match the overall gains of the market with an Exchange Traded Fund (ETF).

Index Funds and ETFs

Ever seen a chart of the Dow Jones Industrial Average (DJIA)? Or the S&P 500? This one shows the S&P going back to 1927, adjusted for inflation: Source: MacrotrendsThe Dow and the S&P 500 are both market “indexes”, meaning they each take a bunch of individual stocks and measure the collective performance of the whole group. Do you want to know something that blew my mind the first time I heard it? For being such an important metric, the Dow only has 30 stocks in it. (The S&P has – you guessed it – 500).The chart above shows what you probably already know: there are times when the stock market dips (and sometimes it takes years for it to recover), but historically, it goes up over the long run.An ETF is a simple, reasonably safe way for you to reap those long-term market gains. Think of it like a basket of stocks. If you buy an ETF, you basically own tiny slivers of all the stocks in the basket. An ETF that tracks the S&P 500 owns some or all of the 500 stocks in that index. The Vanguard 500 Index ETF (ticker symbol VOO) is a great example.If you’re willing to leave your money in an S&P 500 ETF for the long haul, this is a great way to get your foot in the door of investing. Your ETF will go up and down with the broad stock market, and you’ll mitigate your risk of an Enron-type event because there are 499 other companies in the basket. (I don't typically recommend Dow ETFs because there are only 30 companies in the index.)Is there still risk? Absolutely. An S&P 500 ETF can easily go down 25% or more in a year. Could you lose all your money? It’s possible. But only if all 500 companies in the S&P fail at the same time, which is highly unlikely.So if you’re looking to get into stocks, but you don’t have the time to research hundreds of different companies, an S&P 500 ETF is a great way to go.

A Parent's Dilemma: Saving for Their College Tuition vs. Your Retirement

It's heating up in Austin and I'm definitely in summer mode. The girls are practically living in our new inflatable pool (amazing ROI for a $20 purchase), and life is good.Speaking of the kiddos, last month I wrote about college savings options in Texas. One of the questions that comes up again and again for clients with children is how they should be saving for college. For many, paying for college is a huge priority, and understandably so. But what happens if those tuition bills jeopardize your retirement plan?Not surprisingly, some of the conventional wisdom on this topic is overly simplistic. It goes something like this: "Are you terrified by the student debt epidemic? Do you want to ensure your children won't have to live in your basement to pay off their mountain of student debt? If so, then make sure you take on as much of the financial burden as possible. You'll feel like a great parent and your kids will be on the road to happiness."For some people, this plan is just fine. But it only works if you already have your retirement savings well underway. Paying for college is a wonderful gift to your kids. But an even better gift is not asking them for financial support when you are retired.In the perfect scenario, you'll have plenty of money to retire AND plenty of money for four (or five) years of college. But if this doesn't sound like your financial reality -- and it isn't for many American investors -- then it may be worth thinking about how much of your savings should be allocated to college accounts and how much should be allocated to retirement.This can be complicated. You'll need to think about all the usual details relevant to retirement questions -- your current & projected income, target retirement age, annual family expenses, etc. -- and then consider when tuition bills will hit: In your forties? Fifties? Sixties? What you want to avoid is spending most (or all) of your savings on college and then having to start saving for your own retirement later in life.Here's an option I often discuss with clients: Instead of paying for college when the tuition bills arrive, take out loans to pay the tuition and then help pay off the loans AFTER you reach retirement age (59 1/2, according to the IRS). If you can look at your retirement accounts at that time and feel like you have enough, then you can make withdrawals and gift any extra money to your kids to help them pay off student loans. You'll be giving from a position of financial strength, and that's always a good position to be in.Think of it like this: When you're on a plane, the airline says you're supposed to put your own oxygen mask on before helping your kids with theirs. Maybe it's OK to prioritize your own retirement over other important financial goals, even your kids' college.

Saving for College in Texas: Texas Tomorrow Fund vs. 529 Plan

It’s graduation season, and if your Facebook feed looks anything like mine, it's full of happy kids in caps and gowns, graduating and moving on to the next phase of their lives.It’s an exciting time with much to celebrate.  But it also raises a lot of questions about college and (gulp) how to pay for it.To keep it simple, in Texas you generally have two options: (a) the Texas Tuition Promise Fund^sm, or (b) a 529 savings plan.With the Texas Tuition Promise Fund^sm, you’re basically locking in today’s tuition prices by buying “tuition units” to be used at a future date.If your child goes to a public college or university in Texas, you save the difference between today’s cost and the future cost. How much is public tuition in Texas expected to rise? According to data collected by the Texas Tribune, tuition at UT-Austin increased by an average of about 7.3% per year between 2002 and 2015. Other campuses were a little higher or a little lower, but I think it’s reasonable to assume the trend will continue.There are downsides to a pre-payment plan. First, if your child goes out-of-state or attends a private university, your units won’t be worth full-price. Second, the units can only be used towards undergraduate tuition (not room & board, not grad school). Third, you could potentially earn more by investing the money in a mutual fund with a healthy allocation to stocks.The structure of a 529 savings plan is quite a bit different. The account is similar to a Roth IRA, except that distributions from a 529 are used to pay tuition, room & board, and other qualified educational expenses.The 529 has an owner (usually a parent) and it also has a beneficiary (usually a child). Post-tax contributions are made to the account, then the owner chooses how to invest the money (you are given a menu of mutual funds to choose from). When the money comes out of the account to pay for qualified higher education expenses, distributions are tax-free.Distributions from 529s can be used at nearly any college in the U.S., public or private. You can use the money to pay for tuition, but also for on-campus room and board, graduate school, and other specific education-related expenses (the IRS has a list in this PDF, see p.57). And, like the prepaid tuition plan, if the original beneficiary doesn’t use up all the money, you can change the beneficiary to a sibling, another relative, or even yourself.There are some downsides, here, too. First, you have to choose the investments in the 529, and assuming you want your investments to outpace tuition inflation, that means a healthy allocation to stocks. For people with a low risk-tolerance, a 529 may not be the best choice. Second, if you take the money out for non-education related expenses, you’ll owe taxes on the earnings, plus a 10% penalty.So which is the best choice? As usual, I’m going to punt this question back to you. What are you trying to do?Personally, I prefer the flexibility and the higher upside of the 529 plan. I went to college out-of-state, so I can see my daughters doing the same. I also went to private university, so there’s that, too. But if you know your child will attend a public university in Texas, then the Texas Tuition Promise Fund probably has a better risk/reward profile.Next month, I’ll be sending a follow-up post on my own personal, professional and somewhat controversial view on where saving for college should fall within a family’s priorities. In the meantime, congratulations to all the recent graduates in your life!