Seven simple steps are all you need to invest successfully.
1. KNOW WHY – Know why you are saving in the first place, and exactly how and when you plan to complete your savings goal. Write out an Investment Policy Statement (IPS) that includes what you will do under every situation and that documents the decisions made in these steps. The IPS is important so you can manage in both good and bad times. Follow the plan and stay the course.
2. UNDERSTAND RISK – Know what your risk tolerance is. See this post for help. Hint: it is not based on how old you are or what you “should” be able to tolerate. It is very individual.
3. SET PORTFOLIO RISK – Set your stock-to-bond allocation based on your risk tolerance. Ensure the stock allocation is no more than 80% and not less than 20%. The same goes for bonds.
4. SET FOREIGN ALLOCATION. Within the stock part of the allocation, decide how much will be for foreign stocks vs. domestic. Ensure the allocation to foreign is no less than 20% and no more than 50%. No-Robo guy recommends choosing a range between 30-40% foreign to maximize portfolio diversification while considering expected return.
5. SLICE AND DICE – Decide whether to slice and dice. If you choose not to, skip to the next step. Simplicity works and fewer fund selections is less hassle. If instead, you choose to slice and dice, consider starting with a total market index, then adding “tilts.” For example, buy a Total Stock Market Index fund, then add only the categories of domestic REITs and Small Cap Value, each at no more than 25% of your domestic stock allocation. For the foreign slices, consider adding only the categories of Emerging and Small Cap to a Total International Index fund or Total Developed Markets Index fund. Avoid smart beta, robo advisors, gold and other commodities, and emerging market bonds. For details, see this post.
6. SET BOND ALLOCATION – You can set the bond portion from step three with just a Total Bond Market Index fund and be done! If you decide to slice and dice here, allocate between 20-40% of the bond portion to TIPS/I-bonds, and between 10-20% to High Yield. NOTE: If you include High Yield, you should reduce your overall stock allocation by 5% due to its equity-like risk. Example: if, during step three, you allocated 40% to bonds after adjusting for high yield, then your 40% bonds slices might be: 20% Total Bond Market Index, 15% TIPS, and 5% High Yield. If you decide to include foreign bonds, only use the Vanguard fund because it is currency-hedged and has low enough expenses. No-Robo guy avoids foreign bonds and high yield bonds, and his fixed income portfolio is mostly intermediate treasuries, with slices to TIPS/I Bonds, investment grade corporate bonds, and high yielding (but FDIC-insured) savings accounts.
7. REBALANCE – When the primary allocation (stocks versus bonds) changes by more than 5%, rebalance the ratio back to your allocation. For example, your allocation is 50/50, but rising stock prices have caused the stocks percentage to grow from 50% to 55%. Sell stocks and buy bonds until the correct level of market risk is returned to 50/50. If stocks fall from 50% to 45%, do the opposite.
Asset classes within the categories of stocks or bonds (like TIPS for bonds, or foreign for stocks) should be rebalanced when they move 25% from their set portfolio-level allocation. For example, if foreign stocks are 40% of a 50% stock allocation, they are 20% of the total portfolio. If the 20% allocation rises by 25%, the threshold for rebalancing is 25% (the calculation is 0.2 x 1.25 = 0.25). Then, you would need to rebalance foreign back to 20%.
Set and follow the frequency of rebalancing within your IPS. If you are in retirement, annually rebalance in conjunction with taking withdrawals, and by withdrawing first from those classes whose amounts have drifted above their target allocations. But, if you are in accumulation stage, and if you can rebalance with no transaction costs or tax costs (for example, mutual funds in a 401(k) plan), rebalance every six months or once a year. Intervals of every two years are acceptable for accumulators as well. Accumulators may not need to rebalance at all if they direct new contributions to the underweighted classes.