I really like the space of personal finance, retirement planning, and asset allocation. A lot of friends refer to me (despite the fact that I am not a financial advisor) for my random obsessions in the space. I find myself explaining a lot of the same things over and over. I also find myself annoyed by misinformation in the space. This will be a concise TLDR for those that want to get the gist for how “most” people should approach investing. Particularly, long-term investing / investing for retirement. I am not interested in short-term bets and investing, which arguably depending on who you ask, is likely speculation or maybe just gambling.
There is a cost with tinkering with a well-designed plan
Create an investment policy statement. This is a document outlining your asset allocation, how you intend to rebalance, what securities you will use to capture your asset allocation, the reasoning behind your allocation, etc. And then stick to the plan for decades. Make sure that it is a good plan that you can keep to and not tinker. Studies show that one of the worst things an investor can do is tinker with their portfolio or chase trends. Don’t drift from the plan. And the corollary to this is that the best asset allocation is often the one that you can stick to.
Hold low cost, broadly diversified, index funds
It’s not about mutual funds vs ETFs, as this debate is simply around the characteristics of these investment containers, such as how they are priced, sold, taxed, and so on. What you should ask is whether you should take on actively managed funds (which can be either ETFs or mutual funds) or take on index funds (which can be either ETFs or mutual funds). The evidence is clear. Most actively managed funds underperform their index counterparts over long periods of time, after fees. Use index funds to capture the market.
Simplicity is king
It is very easy to overcomplicate your asset allocation. You can capture the global market with a single fund like VT. You do not need a lot of funds to capture what you need. Keeping it simple will be beneficial to keeping you from drifting away from the plan. It also makes it easier to rebalance when there are fewer funds.
Don’t try to beat the market
What we know about stock markets is that they are quite efficient. Efficient markets refer to the characteristic that all available information is immediately reflected in the price of the securities. If markets are truly efficient, then no individual person can regularly outperform the market. In practice, markets turn out to be quite efficient in that sense. Active managers find themselves unable to outperform the indexes over long periods of time. If they are unable to beat it, then what is the chance that you can by managing your own portfolio? Instead, hold the index and enjoy.
Time in the market beats timing the market
Invest at the earliest opportunity. If you have cash that is intended to be invested, then invest it. We know that those that invest $X amount all at once, have a statistically higher chance of outperforming the person that invests the $X amount over time. This is the lump sum vs dollar cost averaging debate, which lump sum simply wins. So avoid hoarding cash and waiting for a dip. Just invest it. We’re here for a long time.
Global diversification is important
Most people will agree with pretty much everything I write here. But you will find a large camp of people who won’t buy into global diversification. They will diversify within the US stock market, but they will refuse to hold equities outside of the US. This is a combination of biases. Home bias, a bias towards your home and things you are familiar with. Recency bias, a bias towards recent great performance of the US market. Survivorship bias, a bias towards things that we are familiar with that survived, forgetting things that died. And more. If we look at Japan, it was once the largest stock market in the world. Now it isn’t. The beauty of global diversification is that you are holding imperfectly correlated assets, so if one zigs, the other may zag. This increases your reliability of outcome and reduces the dispersion of outcomes. So don’t listen to people who say you should only hold the S&P 500. Buy the global stock market at market cap weights.
Eliminate unsystematic risk
Unsystematic risk or idiosyncratic risk, refers to the risks associated with individual companies and industries. An example of unsystematic risk would be a company releasing its earnings report and their stock tanks. These are the risks that you can diversify away by holding the entire market. Systematic risk on the other hand, is the risk that is associated with the market and cannot be diversified away. Examples of systematic risk includes global war, rising interest rates, etc. Since these risks are associated with participating in the market, it can’t be diversified away by participating in the market. However, we can avoid unsystematic risk. People often take on unsystematic risk by holding their employer’s stock, which concentrates their portfolio in a single company. People who pick individual stocks also find themselves taking on this risk. To avoid unsystematic risk, one can hold the global stock market in market cap weights, and avoid holding individual stocks or sector funds.
Minimize fees and taxes
Use your tax-advantaged retirement accounts. This includes the Roth accounts (Roth IRA and Roth 401(k)), which gives the tax benefit on eligible tax-free withdrawals. This includes the tax-deferred accounts (IRA and 401(k)), which gives a tax deduction in the present year. It is up to you to decide which is better and whether you are even eligible to contribute (there are rules). Similarly, make use of accounts like 529 savings plan for future education expenses and accounts like the HSA for growing your dollars in a tax-sheltered account. Taxes will drag long-term returns, so make use of these vehicles. Also, there are brokerages and funds that you can use that come at little to no cost in fees. Use them.
The risk to expected return trade-off has a term structure
We know that risk, as measured by volatility (standard deviation), and expected-return are positively related. But this trade-off actually has a different behavior depending on the time horizon of the investment. In the short-term, volatility is a good measure of the risk of the asset. But for a long-term investment on the order of decades, volatility isn’t as great of a measurement. Take the stock market over long periods of time, short-term volatility becomes noise. Take cash over long periods of time, inflation will hurt it. People will typically think of risks in terms of the short-term volatility, but one form of risk is the risk of not meeting your future consumption. This type of risk appears in more conservative portfolios that don’t take on stocks. There is a cost to pessimism and conservative portfolios in long-term investing.
Economic growth and stock returns are unrelated
A common misconception is that economic growth explains stock returns. The expectations that a company, country, or industry will experience economic growth (or not) are reflected in asset prices. So if a country has high expectations of economic growth and then it meets its expectations, then its stock returns will not be all that spectacular. If a country or industry has low expectations of economic growth and then it overperforms its expectations, then its stock returns will be spectacular. Similarly, high expectations and not meeting them will result in negative returns. So it isn’t economic growth that determines the returns of assets, but rather economic growth AND the expectations that are reflected in the prices of the assets. This gives us a very random relationship that we cannot predict. And this also indicates that those that chase more expensive and trendy and high-performing assets may be in for a surprise, as they are paying high prices (due to high expectations priced in), which indicate lower expected returns.
Beware what people sell to you (even me)
People often have incentives to say what they say. Financial advisors may make something seem more complicated than it really is so they could attract you as a client. A Youtuber might try to sell you a narrative about how doomed we are so that they get viewership over the sensationalism. Educate yourself and stay alert.
You are your worst enemy
Index fund investors who panicked in the past when things went south will always tell you how much they regretted panic selling. Ignore the noise. The world may look like it is falling apart. We’re long-term investors. Easier said than done, but stick to the plan. A well designed plan should have an emergency fund in the case of unemployment. Such a plan should anticipate these market downturns and alleviate the stress that one might feel about staying in the market during these events.