In this class we will discuss the best investment strategy for everyone. Now this is sort of a loaded statement as it’s probably obvious that there isn’t one investment strategy that is perfect for everyone but there are many basics that will ring true for all investors. If you haven’t read our post FIRE 101, which talks about the basics of becoming financially independent and thus having the option to retire early, please check it out. There are as many different investing strategies as there are investment managers but this class is meant to focus on the basics of portfolio design within the constructs of the FIRE lifestyle and community, which is mostly based on low cost index fund investing.
First let’s explore the different types of accounts available to hold our investments in.
401K – Usually provided by an employer but can be for business owners. 401K accounts are employer sponsored accounts where the company will usually offer a matching program where they invest dollar for dollar in your account, matching your contributions up to a certain percentage. 401K contributions are pre-tax, meaning they are not taxed going in and are allowed to grow tax free within the account. Income and asset appreciation are not taxed.
Traditional IRA – Similar to the 401K but with smaller contribution limits and instead of contributions coming out pre-tax they are able to be claimed on tax returns to reduce your taxable income.
Roth IRA – Retirement account where contributions are taxed going in but allowed to grow tax free and be withdrawn tax free. Income and asset appreciation are not taxed.
Brokerage account – Individual account where contributions are taxed going in and when withdrawn. All earnings in the account are taxable but not asset appreciation until sold.
Now that we have discussed the various types of accounts to hold our investments in let’s explore the different types of investments we can use.
Large Cap, Mid Cap, Small Cap – Each category of Large, Mid, and small cap refers to the actual capitalization of the companies in the fund. So large cal would be the 500 largest companies based off market capitalization and small cap would be the smallest companies based off market capitalization
Total Market – Basically what it says, fund that tracks the whole stock market
Foreign stock index fund – Can be Large, Mid, or small cap just like above or total market also. It tracks foreign stocks outside of the USA.
R.E.I.T index fund – Real estate investment trust are investments in commercial properties. A REIT index fund will track either certain sectors or the whole market
Bond index fund – A bond index fund will track the bond market or a specific segment of the market depending on the fund.
Now that we know what type of accounts we can use and a broad understanding of the types of index funds available to invest in, let’s look at how we can actually build a portfolio. It has long been said that you can do this simple math equation to determine you allocation of stocks/equities to bonds (100 – current age = Amount of stock in portfolio) So for me it would be 100 – 36 = 64. So according to traditional wisdom I should have 64% of my portfolio in stocks and 36% in bonds. While this is a simple and time tested method let’s look at what some other famous people suggest.
JL Collins author of The Simple Path to Wealth and well known blogger, suggest using only two funds VTSAX (total stock market) and VBTLX (total bond market) over at his blog at https://jlcollinsnh.com/2014/06/10/stocks-part-xxiii-selecting-your-asset-allocation/
Paul Merriman a famous investor and long time champion for index funds shares the same philosophy of Mr. Collins but suggest adding in small cap plus foreign and emerging market funds, which he shows will yield a slightly better return over time. You can check out his material at https://paulmerriman.com/the-ultimate-buy-and-hold-strategy-2017/.
Scott Burns the person who created the Couch Potato portfolio shares Mr. Collins approach and suggest holding only two similar funds VFINX (total stock) and VBMFX (total bond) You can see more at https://couchpotatoinvesting.com/
Dave Ramsey who is world famous for his debt snowball system and for helping thousands of people to rid their lives of debt recommend a four fund portfolio. Growth and income. Growth, Aggressive Growth, and International. It should be pointed out that Mr. Ramsey is a big advocate of mutual funds and most FIRE investors are not, but it is interesting to see the similarities in his portfolio investments and you can find them at https://www.daveramsey.com/blog/how-to-invest-in-right-mix-mutual-funds.
Ray Dalio is a billionaire investor who runs one of the world’s largest hedge funds and the main character in Tony Robbins’ book Money Master the Game suggest what he call the all weather portfolio, which consist of stocks, long term bonds, intermediate term bonds, commodities, and gold. As you can see his portfolio is probably what we would consider the outlier in the group but he obviously knows what he is doing. To learn more check out his Bridgewater website
In closing as I said earlier there is no one size fits all when it comes to portfolio design but there is one big secret that I will tell you. The best investment strategy is the one you can stick to, yep that’s right, after all this the best piece of advice is to pick a simple strategy that you can stick with for the long term and just keep plowing money into it. Jack Bogle was famous for saying to just keep investing and not even look at your account until you are ready to retire but make sure you have a cardiologist present because you are going to be shocked at how much money you have. The truth is that most of the losses the average investor suffers is what we call self inflicted wounds, meaning it is not due to the market but due to their own irrational fears or desire to try to time the market. While some in the FIRE community dislike Dave Ramsey, he is correct when he says that it isn’t as much about whether you use mutual funds or index funds, rather it’s about actually getting started saving and investing and leaving it alone to let compound interest work it’s magic.
There is one more piece that is worth mentioning. The reason for holding stocks and bonds in an account is because they are non-correlated or basically they tend to move or react differently to economic fluctuations. Historically stocks have yielded a much higher return than bonds but bonds tend to be more stable and prevent large losses in the account value, which may cause many investors to lose their grit and sell at the wrong time, thereby locking in big losses. So as we age they say to move more into bonds because we are getting closer to retirement where we will be more dependent on our savings rather than our ability to earn income. So here is the question, since we need stocks to participate in the growth and appreciation but need to lessen our exposure to them the closer we get to retirement but need to keep some to ensure we don’t run out of funds and at least keep pace with inflation, then how does someone who is planning on retiring early need to allocate their portfolio? Well if you are 30 and want to retire by 40 then you are only 10 years away from retirement, so by normal wisdom you would have a very small exposure to stocks, however because you plan to have a much longer retirement than traditional, in my opinion you will need to actually have more stock exposure to ensure you money last for 40 year. I am currently 36 and plan to retire from full time work by 45, by then we hope to have enough rental income and business income to live off, as we will have retired all of our mortgage debt and only have basic food, insurance, utilities, and fun money to worry about. We do have four kids but we have been saving for their college in 529 accounts. So this is my current allocations in my various accounts.
60% – large cap S&P 500 index fund
20% – International non-US
20% – Total bond index fund
60% – VOO
20% – VEU
10% – BND
10% – VNQ
50% – VTI
20% – VYM
20% – VEU
10% – VNQ
70% – VTI
30% – VEU
This is important to mention. This is PERSONAL finance and this is our personal asset allocations. Ms. FU and I are both employed and have what we consider stable jobs, plus we could easily live off either of either of our incomes alone. Our goal is to live off of the 401K and slowly convert the RMDs from the IRA to the Roth account as the Roth is basically an inheritance to our kids along with a couple brokerage accounts to help cover the tax cost of the tangible assets they will receive. I should also mention that these are my accounts and Mrs. FU has her own similar accounts as I do but they are not included nor their holdings.
Thank you for joining us and remember that we are not licensed financial advisers or tax professionals, please consult with your financial specialist before making any financial decisions.