In the “Building Block” series, we’ve looked at the following three key elements (click on title of each to view the article):
1) The Levers of Wealth (Spend Less than you earn, and do it for a long time)
2) The Most Powerful Force In The Universe (Compounding, start early!)
3) How Much Fuel is In Your Tank (Net Worth Statement to track progress)
In today’s Building Block edition, we’ll focus on “Where Should I Put My Money”? Assuming you’re now spending less than you earn (if you’re not, make it a high priority to get there as quickly as possible), this building block will focus on recommendations for how to invest your surplus. Specifcally, we’ll look at the sequence of priorities you should have for where to direct your excess funds.
Following is the sequence I would suggest. Please note these are suggestions only, and every individual situation may dictate different priorities. However, this list should serve as a logical starting point. Note that I’ve included a few representative mutual funds from the Vanguard family as examples, including their expense ratio (what expenses the funds charge, as a % of your holdings in that fund) and average annual return over the past 5 years.
I would strongly encourage you to investigate funds for your personal investments before investing. A good place to start your search is with Money Magazine’s “Top 50” Funds, available by clicking the hyperlink in this sentence. Keep an eye on expenses (lower is better), and avoid any funds which charge fees to open an account. Once you find a good fund for your purpose, simply go to the fund’s website and start the process (it’s very user friendly to open accounts, link them to your checking account, set up automatic monthly transfers, etc.)
1) Emergency Fund: You should prioritize your first “surplus” dollars into building an Emergency Fund equal to one month of your living expenses. It’s often argued you should do this prior to even paying off debt (I suggest you attempt to do both simultaneously). After you’ve paid off expensive debt and begun to move further into building your investments, you should revisit the Emergency Fund with a goal of ultimately building a 4-6 month savings here, depending on the risk to your income. Example Fund: Vanguard Prime Money Market Fund (VMMXX), expense ratio 0.16%, average 5 year return .03% (no, you won’t earn any money in “safe” money market funds in this low interest rate environment, but your Emergency Fund is about safety, not generating an investment return).
2) Employer Match in 401(k): If your employer offers a savings plan with an “employee match” (e.g., you put in 6% of your earnings, they match with an additional 3%), this should be a very high priority for your savings. This represents a 50% return, the highest you’ll find anywhere. At a minimum, always target to contribute at least the amount your employer matches. Ideally, you should target 15%+ into your employer savings plan. The investment choices within your employer sponsored plan likely vary, but contain funds similar to those outlined below. These can also include tax favorable structures such as IRA’s, Roth’s, etc. For Building Block 4, I’m avoiding the question of IRA vs. After-Tax savings vehicles, as any of the investment asset classes cited below can be saved into either type of account.
3) Broad Equity Fund: Once you’ve built your Emergency Fund, a good first choice for investment dollars is a broad-based equity (stock) mutual fund. The advantage of this approach is that it typically allows low monthly contributions (I started many years ago contributing $50/month into my first investment) and allows diversification among a large group of companies, which reduces your risk. Example: Vanguard S&P 500 Index (VFINX), expense ratio 0.20%, 5 year average return of 14.2%.
4) Diversified Bond Fund: As you are building equity exposure, you’ll also want to begin looking into “Asset Allocation”, which simply means allocating your assets across different types of investments (I’ll go deeper into the theory in future articles). Ideally, this diversification reduces the volatility of your investment returns (as one fund goes down, the other increases or loses less, reducing your overall loss vs. having all of your investments in one type of asset). A “typical” asset allocation model will look at “Equities vs. Bonds”, with varying %’s in each based on your situation and risk tolerance. One commonly held model is to subtract your age from 100, and use that as a general guideline for the equty/bond split (for example, if you’re 30 years old, your split would be 70% Equity / 30% Bonds). Example: Vanguard Intermediate Term Investment Grade (VFICX), 0.20% expense ration, 5.6% average 5 year return.
4a) Blended / Target Date Funds: As an option to Items 3 and 4 above, many employee plans have “Target Date” funds, where you can invest your money in funds based upon your projected retirement date. These funds contain both diversified equity and bond funds, and will reallocation your funds to a higher % bond exposure as you approach/enter retirement (note that various funds target different allocations, you should check with your plan sponsor for details. You can also purchase these directly from many mutual fund companies. (Example: Vanguard Target Retirement 2035 (VTTHX), currently 82% domestic/international equity, 18% domestic/international bond), expense ratio 0.18%, 5 year average return 10.8%)
5) International Equity / International Bonds: As your portfolio grows, you should begin to diversify your exposure into a broader global mix of stocks and bonds. As a general rule, people tend to have a “home market” bias, and you should work to overcome this by directing some investments into other regions to diversify risk of a regional downturn. Also, some international markets (e.g., emerging market) have the potential for much higher investment returns, though that carries with it higher risk of volatility. Example: Vanguard International Growth (VMIGX), expense ratio 0.47%, average 5 year return of 8.5%
6) Small Cap / Growth / Dividend Funds: As you advance in your investment knowledge, you should continue to diversify your equity investments across various equity classes, including small companies, fast growing companies, companies that offer steady dividends, etc. The percentage that each of these should take in your portfolio will be dependent on your situation (e.g., as you near retirement, you should have more dividend funds for retirement income). Examples: Vanguard Small Cap Growth (VISGX, 0.23% expense ratio, 14.5% 5 year return),
7) Real Estate Investment Funds: As funds that invest in various real estate sectors (e.g., commercial buildings, development companies, etc) these funds offer nice diversification from equity and generate solid income. They are at risk in rising interest rate enviorments, and during real estate downturns. Any account over $200k should have at least 5% in REITS, in my personal opinion. Example: Vanguard REIT Index (VGSIX), 0.26% expense ratio, 15.7% average 5 year return).
8) Individual Stocks: You’ll notice these are very far down my list. That is intentional, as my personal opinion is that an investor should avoid picking individual stocks until they have at least $200k invested in the prior asset classes and have gained investing experience. The lack of diversification which results from buying individual stocks is a serious consideration. Also, any funds you invest in individual stocks should be money you don’t need for at least 5 years, and can tolerate a downturn. Also, have an exit plan when you make your purchase (e.g, put in a “traiiling stop loss” order, which will automatically sell the stock if it declines by the % of your choosing. I tend to use trailing stops in the 5 – 10% range, depending on the volatility of the stock.). Conversely, sell a call option (well beyond the scope of this article, but a very useful technique which I may address in a future blog).
9) Alternatives: Well down the list is this broad range of asset class, reserved for a diverse class of investments ranging from precious metals (see Blog #9 “Should I Buy Gold”), commodities (e.g., agriculture, oil), 2X Leverage Funds (e.g., inverse interest rate bets), currency, etc. These should only be reserved for very experienced investors, but bring a lot of “fun” into the game. You should only invest monies into these types of funds which you can afford to lose, and even at that they should not exceed 10% of your investment portfolio.
So, there you have it. Building Block 4. It’s turned into a lengthly blog, but I hope you find value in the ideas presented.
I’d love your feedback on the content, or send me a private email at fritz@theretirementmanifesto if you’d like to discuss your situation in more detail.
Dedicated to Helping People Achieve A Great Retirement!
The Retirement Manifesto
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