As a happy coincidence, a blog post's merit is in its brevity and equally a match is my knowledge of investing for retirement, but believe me when I tell you that I know more than I need to. In fact, here is a great TL;DR (and if that’s too long, just buy this.)
The one free lunch in investing is asset allocation for diversification.
“Oh, if that’s what’s for lunch, then you better be serving desert,” I hear you quipping, “Diversification? Really? Do you think we haven’t heard that old song before?” Well, I hope you have, but I want to make sure you know about the subtle trick that actually makes it work. If you don’t know this one facet, you will be missing out on incredible opportunities and merry piles of cash. Those big shots on Wall Street aren’t going to tell you this – they want to keep it all to themselves! But, you can have this one vital piece of information for the low, low price of three easy payments of $19.95! Or, just keep reading.
What’s My Number?
Your asset allocation, or the percentages of classes of stocks and bonds you invest in, depends on your proximity to retirement and your risk aversion level.
Are you within 10 years of retiring? Then start getting out of stocks and into bonds. The stock market is too volatile to be risking a major downturn.
Does losing 15% or more of your savings in a year make you either queasy or want to punch a dolphin in the mouth? Then stick more to bonds and index funds of US stocks, like VFINX.
Otherwise, split your asset allocation between these classes of investments (in general order of riskiness, but put some in each):
- Domestic Bonds
- Global Bonds
- Large Cap Domestic Stocks
- Small Cap Domestic Stocks
- International Stocks
- Real Estate Funds (REITS, e.g.)
As a 30-ish, somewhat risk-averse investor, my asset allocation is 10%, 10%, 30%, 30%, 15%, 5%. If domestic stocks are the meat of this free lunch, then real estate funds are the spice that makes it nice. I guess that makes bonds the potatoes - don’t fill up on those, and international stocks the wine, complete with their share of headaches.
How to Spread it Out
Between you, your spouse, and all your previous jobs and their potentially lingering retirement accounts, you likely have a lot of options on how to make your asset allocation. I try to keep things simple by sending my previous jobs’ retirement funds into a Vanguard retirement account because they have some of the lowest management fees around. I also use that Vanguard account to save any extra money on top of what I’ve put into my current employer’s plan, making sure that I at least get their matching contribution.
I have a 2-year old son who I’d like to see go to college some day if college is right for him. The way college savings accounts are setup, it makes it risky to invest in those until you are sure that your child is actually going to go to college. A better option is to fund a Roth IRA, which you can do at Vanguard, because at any time and any number of times you can withdraw the money you have put in without any penalty or reason necessary. If I put in $5,000 for 10 years and it grows to $80,000 in that time, I can take out some or all of my $50,000 without any penalty or any reason necessary. Pretty sweet deal! Keep in mind, though, that it may be a better financial investment to do the tax deferral of a 401k or similar rather than the after-tax of the ROTH.
In general, look for funds with both low management fees (under 1%, many of Vanguard funds are under 0.2% because they are software-managed) and a 4-or 5-star Morningstar ratings. An R-squared of 90 or higher can be a good sign that the fund is not volatile in comparison to the benchmark, which would be 100. You can find some of this information on Google Finance and Morningstar, including information on how to fit them into your asset allocation (more on this below).
Too much to handle? Hire a fixed-price financial advisor for a consultation. The advisor should charge somewhere around $1,000 or less and meet with you at least twice. The advisor should help you determine your asset allocation and look at all the funds you have in your retirement accounts to help you pick the best ones. You will learn a lot from a good advisor!
Tracking Your Investments
Now that you have picked your investments you may want to track how they are doing and how well your actual asset allocation is tracking against your goal.
I can tell you one frustrating thing from experience – you cannot tell how well your investments are doing from your brokerage reports. They seem to intentionally make it impossible to see a simple year-to-date yield percentage because they show just how much your investment has grown over time, including your contributions! Well, that looks great, but I want to know how much they have earned me! Of course the account has gone up in over-all value, you nit-wits, I’ve been putting money into it!
In order to calculate an accounts Gain in dollars (Gain = Market Value – Contributions) and Total Return % Year-to-Date, I use Microsoft Money Plus Deluxe (Sunset Edition). It’s now free because MS has stopped supporting the software. When you sign in, just check the box to sign in offline. They have somewhat debilitated the Investing menu – it just takes you to a web page instead of getting you to the investing tool you’ll need. So, click on the “Shortcuts” icon in the tool ribbon, and then add “Portfolio” to your shortcuts (the View should be selected “Custom”). Then, a Portfolio menu button should appear in your tool ribbon, and you’ll be able to use that to enter your accounts, funds, and prices. You can configure your columns so that the grid shows your cost basis, gain, and TR. This warrants another blog post in itself, but feel free to drop me a line with questions about it. (As an aside, I also use Money to manage my checking and savings account balances. My bank – US Bank – lets me download transaction data in Money format and I just import it right in)
I created a spreadsheet to calculate my actual and goal asset allocation. The Accounts are entered in column A, and their funds in column B and symbols in C. The account total is then entered in D. Skip column E for the moment, and put select a cell in column F. Now, click Tools > Goal Seek and set the “To Value” to the market value of that fund, then set “By Changing Cell” to Ei where i is the row you are in. That will set the value of column E for you so that you don’t have to calculate it. Then I check Morningstar to figure out the asset allocations inside of the fund and fill out columns G through L. Column M can be left alone, it should add up to 100%. In row 26, you can enter your goal asset allocation. The spreadsheet will calculate the actual asset allocation, compare it to your goal, and then tell you in row 28 how much money you need to withdraw (positive numbers) and move into other classes (negative numbers) in order to meet your goal. (I need to create an app that does this for you, but when I do I’ll ask for money – so enjoy this spreadsheet while you can!)
The Big Secret
OK, now it’s time for the big reveal. This is the one key thing you need to know about asset allocation to make it work for you: Rebalance Quarterly!
Rebalancing may sound obvious, but there is a subtle trick to it that saves you from your own emotions – it forces you to sell high and buy low. Imagine it’s time to rebalance and your Large Cap Domestic funds have done really well, but your International Stock is in the pits. Well, you’re going to have to sell some Large Cap Domestic to buy some International Stock in order to bring the balance back into line with your asset allocation. Don’t think about it, just do it! I know it can be hard, but it really works [citation needed :)].
Investments_template.xls (25.00 kb)