Aug. 7, 2019
In my last two articles, I wrote about how much and where to save for financial independence, but what about growing those savings? How do you strike the right balance between risk and return? When it comes to investing for retirement, there are three main options:
1) Keep it simple stupid. The simplest option of all is to invest everything into a pre-mixed and fully diversified “asset allocation fund” that matches your risk tolerance. You only need one of these funds in your account because they’re designed to be a one-stop-shop.
For example, one of the most common default options for 401(k) plans is a target-date fund. Each target date fund has a year and the idea is to invest everything in the fund with the year closest to when you plan to retire. You can also choose to be more conservative by picking an earlier year or more aggressive by picking a later year because the closer you are to the target retirement date, the more conservative the fund will be. The mix automatically adjusts as you age, so you can simply “set it and forget it.”
Pros: It doesn’t get much easier than this. You choose one fund and you’re done. This can be ideal for someone who has all their retirement money in tax-sheltered accounts and doesn’t want to design their own portfolio.
Cons: It’s not customized to you personally. If you have taxable accounts as well, the mix won’t be optimized for tax efficiency. Some target-date funds also charge higher fees than if you purchased the funds making up the funds directly.
2) Do it yourself. If you want to be more “hands-on” with your portfolio, you can create a more customized portfolio using different funds for each asset class and/or even individual securities. If you’re not sure how to begin, you can start by choosing one of these many model portfolios. You can also use tools like Portfolio Visualizer and Portfolio Charts to compare the past performance and other characteristics of these and any other portfolios you can think of. Just don’t overthink it, because the historical performances of these portfolios are pretty similar and there’s no way to know which will do best in the future.
Pros: You can have a more personalized portfolio that reflects your particular investment philosophy and other preferences you might have. You can also reduce your taxes by prioritizing more tax-inefficient investments like taxable bonds, REITs, commodities, and high turnover funds in your tax-sheltered accounts and harvesting tax losses in taxable accounts.
Cons: It requires more work on your part and the ability to resist the temptation to keep “tweaking” the portfolio in response to the market, which typically ends up backfiring. These portfolios also need to be rebalanced and adjusted as your risk tolerance changes.
3) Get help. This includes working with both a traditional financial advisor.
Pros: A financial advisor can provide the benefits of a customized portfolio without you having to do it yourself. This can be particularly useful for taxable accounts, which require more attention to minimize taxes. Human advisors can also be pivotal in talking you out of making mistakes like chasing speculative “opportunities” or bailing out of your investments during the next downturn.
Cons: Financial advisors cost additional money. In addition, some “financial advisors” sell high-priced investments for a commission to the detriment of other options like paying down debt, contributing more to your employer’s retirement plan, purchasing investment real estate, or investing in lower-cost investments. (You can avoid this by sticking to fee-only advisors that charge hourly, monthly, or annual fees that aren’t based on how much you have invested with them.)
In any case, don’t forget to be conscious of costs when choosing a target-date fund, individual components of a portfolio, or an investment advisor. Studies have found that low fees are the single most proven predictor of superior mutual fund performance when comparing similar funds. In fact, one study found that a typical 1% management fee would have turned the best performing institutional model into the worst performing one. An easy way to minimize fees would be to stick to low-cost passive index funds as much as possible.
Despite all the attention given to investing, it’s actually the easiest part of achieving financial independence. All you have to do is have a reasonably diversified portfolio (target-date fund, model portfolio, or advisor managed portfolio can all count), keep your costs low, and stick with it. This is the one area of life where you get rewarded for being cheap and lazy so take the money you save on investment fees and go enjoy the rest of your summer!
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