If you're about to make an serious financial move--either rolling over your 401k, deciding to retire, or maybe selling your business or deploying an inheritance--you have some important investment decisions to make. What are the biggest considerations before you move forward? I believe there are five decisions you have to think through carefully to achieve the best investment and financial experience.
Yet most people don't know where to begin and I don't remember, in 22 years of working as a financial advisor, ever talking to someone who understood or had evaluated all of them. So let me outline the five investment decisions that really matter, step by step:
#1 -- Invest or Sit on the Sidelines?
This should be an obvious one but it really isn't. I see way too many people with an exorbitant amount of money in savings and money market accounts. These are good parking places for 6-18 months of living expenses, as well as a big ticket purchase you might make in the next three years, such as the down payment on a new house. For all your excess savings, you need to invest it in longer-term, growth and income assets. Simply moving from cash (One-Month T-Bills) to a bond fund has historically netted you about 3% per year in additional returns. The decision to invest with money you can afford to set aside for more than a year or two is crucial. Guessing that the market will go down and you'll be able to get in at a better point is unlikely.
#2 -- Be An "Owner" Or a "Loaner"?
When you buy bonds, you are loaning out your savings to the government or a corporation in return for an agreed upon rate of interest over a pre-set period of time. That's been better than keeping your money in cash, but it hasn't done as well as taking an ownership stake in a business, which is exactly what you're doing when you purchase a share of stock. You become a small fractional owner in the company, and are entitled to your share of earnings growth (through share price appreciation) and dividends. Over time, owning stocks instead of bonds has created significantly greater wealth -- just as the decision to simply invest as opposed to keeping your money in cash has netted you almost 3% a year higher returns, investing in the US stock market (the Vanguard CRSP 1-10 Index) has also netted you an additional 3% in returns compared to a bond index.
#3 -- Which Stocks Should You Buy?
The stock market is dominated by the largest and highest-priced companies. This means that you get a relatively small amount of earnings for each share you own. What's more, due to the intense competition in free market economies, large successful companies have a difficult time maintaining their leadership positions. Over time, smaller and less successful companies with low prices and low past/current earnings have been able to reinvent themselves, boost profitability, and take leadership away from the giant bureaucracies that get all the attention. The result is that smaller and lower-priced value stocks have delivered much greater long-term returns than a large cap growth-dominated market index. To get the most bang for your buck from your stock investments, you need to emphasize the asset classes with the higher expected returns: small cap and value stocks.
Over time, the decision to favor small value stocks over the large growth stocks that dominate a basic stock market index fund has led to over 4% per year higher returns -- a bigger return advantage than the stock/bond decision!
#4 -- Should You Diversify Globally or Keep All Your Eggs In One Basket?
Despite the much higher returns generated by small cap value stocks compared to the basic stock market index over time, you shouldn't bet the farm on any one asset class. Diversification across different asset classes can produce higher long-term returns without commensurately higher risk. Instead of just investing in US stocks, you should spread your portfolio out amongst US and non-US stocks, emphasizing smaller and more value-oriented companies in each region. An example of a portfolio that is well diversified across large/small and growth/value stocks in US and non-US markets is the DFA Global Equity Index.
Looking at the table below, we find that the DFA Global Equity Index's return of +12.5% per year was over 2% annually higher than the Vanguard CRSP 1-10 US Stock Index, without additional risk (standard deviation)! Broad diversification is the only free lunch you'll find in investing.
#5 -- What's The Best Asset Allocation For You?
Having learned how to invest to earn the highest long-term returns without taking unnecessary risk, it's now time to decide how much return you will need and how much volatility and (unpredictable) short-term loss you are willing to accept to achieve that return. Fortunately, once you understand the right way to invest, all of the options are good; there are no wrong decisions. Instead they are tradeoffs -- more pain = more expected gain, and vice versa.
(a) For maximum growth, you can choose an all-stock portfolio, such as the DFA Global Equity Index, with much greater long-term returns and stock market index-like risk.
(b) You could add a small amount (20%) in investment grade bonds and still expect to earn future returns greater than a US stock index thanks to the 80% that remains in stocks, but with less variability.
(c) Or you could opt for a standard retirement allocation, 60% stocks and 40% bonds. This balanced portfolio, with higher expected returning stocks, has historically earned a slightly better return than the US stock market index (which is dominated by the largest growth stocks). But with 40% less volatility and milder short-term declines.
Whichever allocation you choose, the most important thing is to stick with your portfolio through ups and downs. Getting in and out at the wrong time could cause you to miss several % a year in potential gains and could put you at risk of failing to achieve your goals. Once you've chosen your path, you've gotta stay the course.
Unfortunately, most investors have a hard time sitting tight when headlines turn scary, which is why hiring a full-time, independent financial advisor to help you design the right portfolio for your unique goals and work with you to stay the course could be another great decision.
DFA Global Equity Index = Dimensional Equity Balanced Strategy Index
DFA Global 80/20 Index = 80% DFA Global Equity Index, 20% DFA Adjusted US Investment Grade Bond Index (Barclays Bond Index prior to 2/1989)
DFA Global 60/40 Index = 60% DFA Global Equity Index, 40% DFA Adjusted US Investment Grade Bond Index (Barclays Bond Index prior to 2/1989)
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.