Sunday, October 10, 2010

How to Invest Your Savings - Alpha

These are some thoughts for an ordinary person who doesn’t follow markets or business much, but needs to invest his or her savings.

First of all, congrats. The most important financial decision is to pay down expensive debts (credit card debt, especially) and to live within your means. To save. If you’ve done that you should pat yourself on the back. I would suggest you try to save 50% of your after-tax income.

Now to markets and investing.

Generally, for periods longer than 15 years, stocks have higher returns than bonds. However stocks can go down a lot in a single year (a 40% drop or more), whereas bonds usually go up every year (3-5% gains). So you need nerves of steel to buy stocks and hold them (they can also go up over 30% in any given year). Also, stocks follow the business cycle. Every 5, 7, or 10 years (the number isn’t exact), business goes through a cycle when times are good and fat, and then a peak is reached and times become bad and lean. Ideally you would own more stocks at the beginning of the cycle and more bonds at the end. Buy low, sell high. Easier said than done.

So, how to invest?

1) Hold diversified index funds, not individual stocks.
Index funds are meant to match broad markets like the S&P 500 Index (largest US stocks), Barclays US Aggregate Bond Index (broad US bonds), or MSCI AC World Index (largest global stocks) at low cost. Index funds generally beat most mutual funds. Vanguard and Fidelity provide good, low-cost index funds. Generally the biggest index funds are the best (size gives liquidity and pricing discounts – it’s like buying bulk at Costco).

2) Divide your holdings between bonds and stocks.
The percentage of your holdings to bonds should equal your age. So if you are 30 years old, invest 30% in bonds and the rest (70%) in stocks. I would hold about half in a domestic fund and half in an international fund. This is called “asset allocation.” Here are diversified Vanguard funds (International stock fund and a diversified bond fund - note that most of the Fidelity index funds are just as good):
https://personal.vanguard.com/us/funds/snapshot?FundId=0129&FundIntExt=INT
https://personal.vanguard.com/us/funds/snapshot?FundId=0522&FundIntExt=INT

3) Re-balance your holdings every 2 years or so to match your age.
Check your statements every 6 months.

You’re done. That was simple.

So what could make this more complicated? Two things.

First, there’s the business cycle.
If you have a perceptive eye for the world and go to many cocktail parties, you’ll notice that at the top of a business cycle many people will tell you about the killing they’re making in stocks. They’ll brag and then show you something fancy they bought (car, house, boat, trophy wife, other toy, etc.). When you see this happening a lot, sell all your stocks and hold just bonds for a while. When people reach the other extreme (a disgust of stocks due to large market drops and their new toy being taken away due to a foreclosure), go back to your regular allocation, or put more in stocks. The whole process is called “market timing” and experts often discourage it. I call it “going against the herd” and encourage it. At the very least, don’t run with the herd.

Second, there’s inflation. In today’s world, the bank and money system is controlled by central banks, namely the Fed in the US. Every few decades the central bank comes under enormous pressure to create inflation. In the US, the 1970s was one time. I suspect 2011-2019 will be another because of all the deficits and debts that people don’t want to deal with. Inflation is generally bad for all bonds and most stocks. Older people who hold more in bonds are hurt the most. The best things to hold when you expect inflation are energy/metal/commodity stocks and real estate. Vanguard and Fidelity have index funds for these. Generally I think it’s better to hold and manage local real estate, bought at foreclosure sales or from banks. But that takes some gumption, skill, and effort. So most people should stick to index funds. Here are three funds to consider (precious metals, energy, and REITs):
https://personal.vanguard.com/us/funds/snapshot?FundId=0053&FundIntExt=INT
https://personal.vanguard.com/us/funds/snapshot?FundId=0051&FundIntExt=INT
https://personal.vanguard.com/us/funds/snapshot?FundId=0123&FundIntExt=INT

SUMMARY - Some guidelines for investing:
-Buy 3-5 index funds (no more) from Vanguard or Fidelity (they have the lowest fees - no one else can match them).
-Rule of thumb is that the portion of your portfolio in bonds should equal your age.
-Suggested 3 index fund portfolio: 30% intl or US bonds, 40% intl stocks, 30% US stocks.
-Rebalance annually - sell stocks when you feel a bubble is coming (when people talk too much about stocks at cocktail parties). Wait till the crash and recession to go back into stocks.
-Over very long periods of time (20 years), stocks will always beat bonds and cash. For shorter periods, 1-5 years, it's a toss-up between stocks, bonds, and commodity funds - depends on many factors (GDP growth, inflation, corporate profits, TFP, etc.).

Suggested Further Reading for Beginners
Personal Finance:
Personal Finance for Dummies:
http://www.amazon.com/Personal-Finance-Dummies-Eric-Tyson/dp/0470506938/ref=pd_sim_b_4
Millionaire Next Door:
http://www.amazon.com/Millionaire-Next-Door-Surprising-Americas/dp/1589795474/ref=sr_1_1?s=books&ie=UTF8&qid=1341789746&sr=1-1&keywords=millionaire+next+door

Investing
The Intelligent Investor:
http://www.amazon.com/Intelligent-Investor-Definitive-Investing-Practical/dp/0060555661/ref=sr_1_1?s=books&ie=UTF8&qid=1341789762&sr=1-1&keywords=intelligent+investor
Essays of Warren Buffett:
http://www.amazon.com/The-Essays-Warren-Buffett-Corporate/dp/0966446127/ref=sr_1_sc_2?s=books&ie=UTF8&qid=1341789789&sr=1-2-spell&keywords=warren+buffett+essar
Peter Lynch on Investing:
http://www.amazon.com/One-Up-On-Wall-Street/dp/0743200403/ref=pd_sim_b_2
Anything in the "Little Book" Series
http://www.amazon.com/Little-Still-Market-Books-Profits/dp/0470624159/ref=pd_sim_b_12

Reading Financial Statements (Required if you buy individual stocks instead of index funds)
Bernstein on Financial Statements:
http://www.amazon.com/Analysis-Financial-Statements-Leopold-Bernstein/dp/0070945047/ref=sr_1_12?
s=books&ie=UTF8&qid=1341789924&sr=1-12&keywords=interpreting+financial+statements Buffett on Financial Statements:
http://www.amazon.com/Warren-Buffett-Interpretation-Financial-Statements/dp/1416573186/ref=sr_1_2?
s=books&ie=UTF8&qid=1341789924&sr=1-2&keywords=interpreting+financial+statements More on Financial Statements (Intermediate):
http://www.amazon.com/Financial-Statement-Analysis-Practitioners-Finance/dp/0470635606/ref=sr_1_7?
s=books&ie=UTF8&qid=1341789924&sr=1-7&keywords=interpreting+financial+statements

(NOTE: I have no tie or connection to Vanguard or Fidelity, and I get no compensation from them. I've found that these two are generally well-run financial firms that mostly try to do the right thing - this is something quite rare in the world of finance and unlike the rest of Wall Street, which is simply greedy and amoral.)

1 comment:

  1. With technology today anybody with an IQ of 120 plus can do their homework and pick individual stocks. Goto Dataroma and watch what the pros are buying. C AIG MOT RE . Just my observation.

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