Step 6 – Invest in Stock and Bond Index Funds or ETFs

by | 06Oct2017 | Investing, Investments, Steps to Financial Security | 0 comments

Investing in stock and bond mutual funds or exchange traded funds (ETFs) is the simple way to get higher investment returns than more conservative investments like bank accounts, money market funds, or certificates of deposit (CDs). In addition, it is the only way you can invest and stay ahead of inflation.

If you put your money in a savings account that earns 2% but inflation is 3% that year, you just lost 1% of your purchasing power. With historical inflation averaging approximately 3%, you can’t even break even without taking some risk and earning a return of more than 3%.

Investing in stock and bond funds is not for the weak hearted. You can lose money. Over the long term, though, assuming higher investment risk leads to a higher investment return. By owning stock mutual funds and ETFs you are owning a small piece of thousands of companies. The long-term growth of these companies is what increases your net worth. Always remember that the goal is to OWN companies through mutual funds/ETFs, not to TRADE companies with mutual funds/ETFs.

Taking Risk

Only you know how much risk you are willing to take, and you should take as much as you can while still being able to sleep at night. If you invested $1 in the following investments in the year 1802, this is how much money you would have had in 2014:  (Source: A Random Walk down Wall Street: The Time-tested Strategy for Successful Investing)

  • Cash – $19
  • Gold – $85
  • Treasury bills – $5,400
  • Bonds – $29,000
  • Stocks – $18,000,000

I ask again, which would rather have? Assuming increased risk leads to increased return over the long-term, so take as much risk as you can by investing a large percentage of your net worth in stocks.

Invest in Low-Cost, No Load Index Funds

You will have to take a look at the investments offered by the Thrift Savings Plan (TSP), any other retirement plans you might have, or the investment firm you choose to use and select from that menu. The principles to guide you should be:

  1. Favor index funds over actively managed funds. Remember that index funds track a market or market segment, while actively managed funds usually try to beat the market or market segment. We’re investing for the long-term, and over this time frame almost no actively managed funds will beat their index because of their higher costs. In addition, because past performance does not predict future performance, there is no way to predict which funds will beat their index.
  2. Favor mutual funds and ETFs with low expense ratios that do not charge a load, which is a commission charged when you invest or redeem shares. What is an expense ratio? An expense ratio is the percentage of a fund’s assets that is used for expenses. In other words, if you invest in a mutual fund with a 1% expense ratio and that fund makes 10% in a year, you’ll only get a 9% return on your investment because 1% goes to pay expenses. The lower your expense ratio, the more of your gains you get to keep. The expense ratio should be less than 1%, preferably less than 0.5%, and optimally less than 0.25%. If you want to keep this really easy, just invest in Vanguard index funds/ETFs and the funds in the TSP as they all meet these criteria.
  3. As already discussed, realize that in order to beat inflation over the long haul, you’ll likely need to invest some of your portfolio in stock index funds/ETFs. Stocks provide long-term growth, while bonds smooth out the ride and reduce portfolio volatility. What percentage you invest in stocks will depend on your time horizon, risk tolerance, and individual situation. A number of guidelines from trusted references are discussed here:
AGE GROUP PERCENT IN STOCKS PERCENT IN BONDS
20-30s 75-90 25-10
40-50s 65-75 35-25
60s 45-65 55-35
70s 35-50 65-50
80s+ 20-40 80-60

 

  • They also suggest a more aggressive asset allocation, which is my personal favorite due to the protection offered by my inflation adjusted military pension:
AGE GROUP PERCENT IN STOCKS PERCENT IN BONDS
20-30s 100 0
40s 90-100 10-0
50s 75-85 25-15
60s 70-80 30-20
70s 40-60 60-40
80s+ 30-50 70-50

 

  • John Bogle (the founder of Vanguard) suggests as a conservative asset allocation rule that your percentage of assets in bonds should equal your age. In other words, at age 30 you should have 70% in stocks and 30% in bonds. A more aggressive version is to subtract 10 from your age, so at age 30 you’d have 80% in stocks and 20% in bonds.

One very easy way to implement this is to pick target retirement funds as your investments, like the Lifecycle Funds in the TSP and other similar offerings from investment firms. You just pick the approximate year you plan to retire, that year will likely be in the name of the fund (Target Retirement 2030 or Lifecycle 2030, for example), and invest in that fund. Your investments will gradually get more conservative as you age without any action on your part. Just make sure that the target date funds you have access to are composed of index funds with low expense ratios (again, using Vanguard or TSP funds makes this a no-brainer). Target retirement funds composed of actively managed funds with expense ratios greater than 1% exist and are something to avoid.

Not Using Target Date Funds

If you don’t want to use target date funds, you’ll have to pick the funds yourself, but it is very easy. For the TSP, here are your options.

The TSP makes the US portion of your stock portfolio a little more complicated than it needs to be because they don’t have a total US stock market index fund (like Vanguard). Instead they have two funds that cover the US stock market, the C Fund and the S Fund. The C Fund includes stocks of large and medium-sized U.S. companies, like an S&P 500 index fund would. The S Fund includes stocks of small to medium-sized U.S. companies that are not included in the C Fund.

For the international stock portion of the TSP, life is simpler. They only have one fund, called the I Fund, which contains international stocks of more than 20 developed countries. There is no emerging market fund in the TSP.

For your bond portfolio in the TSP, you have two choices (like with US stocks), called the G Fund and F Fund. The G Fund contains US government securities that are specially issued to the TSP. The F Fund contains government, corporate, and mortgage-backed bonds. There is no international bond fund option in the TSP.

At Vanguard, you only need four funds. For US stocks, you use the Total Stock Market Index Fund for US funds, which covers the entire US stock market. For international stocks, you use the Total International Stock Market Index Fund, which covers both developed and emerging markets. For US bonds, you use the Total Bond Market Index Fund, which invests about 30% in corporate bonds and 70% in US government bonds of all maturities. For international bonds, you use the Total International Bond Index Fund, which invests in international government, agency, and corporate securities, mostly from developed countries, but also from some emerging markets.

Recommended Investment Ratios

For your stock funds, you put 60% of your money in US stocks and 40% in international stocks. Where did this ratio come from? Frankly, it is what Vanguard does with its target retirement funds. They are a $4 trillion-dollar company, and their research arm has determined this is the best ratio, which is good enough for me. Many other well educated investors recommend an international allocation that ranges from 0% (like the founder of Vanguard, John Bogle) to 50%, so anything within this range is supported by someone who is an established, well-regarded investor.

For your bonds, I’d put 70% in US bonds and 30% in international bonds for the same reason (this is what Vanguard does). In the TSP, though, there are no international bonds, so I’d just divide evenly between the two bond funds. Frankly, it probably doesn’t matter how you do it with bonds. There are plenty of well-educated investors who espouse all sorts of strategies, including using only US bonds and no international, using only ultra-safe bonds like US Treasuries (the G fund in the TSP), etc. I have never seen anyone recommend only international bonds, so I’d make sure your bond allocation was heavily weighted toward the US.

What About Other Investments?

There are plenty of other investments in addition to stock and bond index funds and ETFs. You can invest in individual stocks, real estate, small businesses, life insurance, precious metals, junk bonds, bitcoin, collectables, options, currencies, and many other things. You don’t need to use any of them to achieve financial security. If you do invest in these things, keep them a small percentage of your overall portfolio, no more than 5-10%.

Rebalancing

At least once a year, you need to rebalance and make sure that your current investment allocation has not strayed too far off from your desired investment allocation. For example, let’s say that you want to have your investments 75% in stocks and 25% in bonds. If after a year your stocks have out gained your bonds and you now stand at 90% stocks and 10% bonds, you’ll want to sell some stocks to purchase bonds. This can reduce investment risk and sometimes increase your return because it allows you to systematically sell what is priced high and buy what is priced low.

When rebalancing you want to try to do this in your retirement accounts (like the TSP or IRAs) because buying and selling these investments will not trigger any taxable transactions. If you buy and sell in your regular taxable account, you may owe taxes on any gains you’ve made.

Another way to rebalance, which is what I do, is to rebalance when you make your investments. Since I invest monthly, I track my overall asset allocation. Whatever I’m low in, I purchase that month with my new investments until my asset allocation is back on track. For example, recently the international stock markets have performed very well, which means I’ve been purchasing US stock funds because I’m underweight in that asset class.

Market Downturns

The market will go down, and when it does you need to resist the temptation to sell investments or stop investing. For some reason people treat investment funds differently than everything else in their life. When you want to buy clothes, a car, a computer, and just about anything else, you look for a sale. It should be the same for your investments.

The best time to buy an investment is when it is cheap and you can get the best deal. When the market recovers, which it will, you will reap the rewards. Focus on the long-term and just keep investing during market downturns.

How Do You Know When You Have Enough to Retire?

How much money will you need to retire? Most retirement planners state that you’ll need approximately 70% of your pre-retirement income to maintain your current standard of living once you retire. This number, though, is heavily dependent on what you consider to be a “good retirement” and what type of a lifestyle you intend to lead. For example, since I save 30% of my gross income for retirement, I’m already living on only 70%, so I highly doubt I’ll need that much when I retire.

If you are frugal and pay off your mortgage, you may find that you need as low as 25% of your pre-retirement income to retire comfortably. You won’t be staying in the Ritz Carlton, but there’s nothing wrong with the Hampton Inn.

There is a lot of uncertainty in life, but the 4% rule is a nice rule of thumb to use when assessing how much money you’ll need to accumulate before you can retire. The 4% rule says that you can take 4% from your retirement savings annually, adjust for inflation each year, and never run out of money. The devil is in the details, but use the 4% rule and assume that you can get approximately $40,000 per year of retirement income from every $1 million you have saved.

Conclusion

Invest in stock and bond mutual funds or ETFs in a ratio appropriate for your age and risk tolerance. Keep investing during market downturns/crashes. Slowly watch yourself get rich.

On to Step 7 – Make an Intelligent Rent vs Buy Real Estate Decision

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