How You Should Invest for Retirement
I first heard of “KISS” when I was in elementary school — no, not the type you do sitting in a tree! I’m referring to “keep it simple stupid”; I have adhered to this concept throughout my life. It’s no different when it comes to how I invest for retirement.
The investment industry constantly rolls out new products to entice retail investors with bells and whistles. It puzzles me how many people are employed by large financial institutions and paid handsomely for giving out overly complex advice on how to invest. It almost feels like they want to sell you something that is difficult to understand just so they can justify their commissions.
Investing for retirement shouldn’t be complicated. Here’s how I keep it simple.
Invest For the Long Term
In terms of investing for the long term, I recommend investors place most of their retirement portfolio into index funds through either mutual funds or Exchange Traded Funds (ETFs). Now, that’s probably something you’ve heard before. The fact is, most active mutual funds have not performed better than index funds after adjusting for fees. Fees on actively managed portfolios are substantially higher relative to the index funds.
Research shows that most active mutual funds do not outperform S&P 500 indices over long periods of time. This means that even the professionals you see on TV generally underperform the broad index.
If an active fund manager has a hot hand and outperforms for a period of time, the manager gets interviewed in magazines and becomes highly rated by Morningstar — an investment research company offering mutual fund, ETF, and stock analysis, ratings, and data, and portfolio tools.
Even though most people have heard the common sense rule that past performance is not indicative of future success, hot mutual funds will always see their assets under management jump as investors try to ride the hot hand.
Most of the time something called “reversion to the mean” kicks in and the fund falls back down to earth. Reversion to the mean (or regression to the mean), is referring to asset prices and returns eventually falling back down to the long-run average.
This is also why there is often a big disparity between the historical published return of a mutual fund vs. the average return of a $1 invested. You can mostly blame investor behavior for that one. Investors usually jump in after hearing about the hot returns and then the fund subsequently does not perform as well.
Using Your Time Wisely
It is always tempting to buy some hot stock that was just featured on CNBC. If only I had a nickel for every time I see an article talking about a stock that may be the next Netflix or Amazon!
Before you start investing your precious time researching what this hot company does, ask yourself if this is the best use of your hours in the day. Remember that your time is limited and should be treated as the most valuable resource you have. Make sure that you are productive and efficient with how you use your time.
So this all comes down to the question you should ask yourself: will spending your precious time researching an idea yield a better result than just buying index funds? I hate to break the news to you, but it’s very unlikely for an individual investor trading stocks to beat index fund returns over long market cycles after accounting for trading fees.
Stick With a Model Portfolio
Due to the number of index funds available in the marketplace, it can get very confusing as to which index funds to buy. What I find happening now is that investors own a bunch of mutual funds or index funds, but they are still not diversified. For example, performance of an S&P 500 index fund is going to be very highly correlated to that of a Total Stock Market index fund.
For a model portfolio, I would put 70% in U.S. stocks, 15% in international stocks and 15% in emerging markets. This allocation is likely different than what you usually hear.
For one, I suggest no exposure to bond funds. As you are accumulating more assets over time, I believe you need to be as aggressive as possible in term of the level of exposure to global stock markets. Playing smart offense and not just defense will help your portfolio grow bigger in the long run. I view bonds as more of a capital preservation tool that can help to minimize the overall volatility of the portfolio. But a lower volatility usually translates to lower returns over the long term.
As your risk tolerance decreases as you get older, you can shift the weight of your stock portfolio to more large-cap, value-oriented, high dividend stock funds. Most of your money should be in U.S. stocks since U.S. companies are second to none in terms of their ability to access capital for growth, experience of management team and financial reporting transparency.
Having some exposure to international stocks, which include developed markets throughout Europe and Asia, will help to lower the volatility of the overall portfolio. Keep in mind that there is a relatively high correlation between the stock market returns in developed foreign countries and that of the U.S.; this means that if one goes down or up, you can expect the other to move in a similar direction.
Due to the long-term growth opportunities in developing countries such as China, India and Africa, it is also important to have some exposure to emerging markets. Emerging market funds will be more volatile than U.S. stock funds and tend to be less correlated to U.S. stock returns than an International fund.
Invest in index funds offered by industry leaders like Vanguard, BlackRock (iShares), Charles Schwab, or Fidelity. I believe you can be fairly diversified with only 4-6 index funds in total.
You need to be knowledgeable about what you are invested in. I wouldn’t try to time the market and trade the funds. Dollar cost average over time and let the law of compounding returns help you reach your retirement goals.