“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” – Warren Buffett
I have a lot of people interested in investment asking me how to successfully do it. They feel like they need just a little bit more knowledge in order to tackle it without an advisor. As a disclaimer I am no financial expert or an investment guru but what I will share with you in this blog is the information I know about investment and doing it yourself.
You’re keen on achieving financial freedom and you’re ready to start investing.
But you’re not sure where to start.
You’ve heard that fees can devour your gains and that the perfect financial advisor is hard to find. You decide to do it yourself (DIY). I mean you were smart enough to finish high school, and diligent enough to start saving some of your little money.
You can do this. Here’s how you get started.
1. Read a book.
Or two or three. The internet is full of great information, but it can be difficult to know where to begin. A good basic personal finance book is organised into a cohesive package of well-written and professionally edited chapters designed to teach you what you need to know and understand to be comfortable managing your own money.
A few I can recommend:
- The Only Investment Guide You’ll Ever Need by Andrew Tobias. The first investing book I read. An updated edition was just published April 26, 2016.
- The Little Book of Common Sense Investing by John Bogle. It’s not a how-to guide, but it gives a good overview of how the markets work, with some fun parables and loads of wisdom from an investing hero.
- The Bogleheads’ Guide to Investing by Taylor Larimore, Michael LeBouf, and Mel Lindauer takes the logic and ideologies of ‘Saint’ Bogle and applies them to everyday investing for people like you and me.
2. Harness the power of the internet.
Once you have some baseline knowledge from reading a book or two, refine that knowledge with a little browsing. Read some articles and blog posts. Read the forums. When you’re ready, ask questions on the forums. You’ll be amazed at the quality information you’ll receive on a quality forum, two of which are listed below.
A few sites to get you started:
- Bogleheads. An extensive wiki and a great forum.
- WhiteCoatInvestor. five years of great posts and an active forum.
- Rockstar Finance. Features three inspiring posts daily Monday – Friday.
3. Estimate your net worth.
It’s hard to figure out how to get somewhere if you don’t know where you are starting from. Look up your balances and add them up. Add home equity if you’ve got any. Look up your debts and subtract them from the assets.
Anonymous people on some internet forums like to quibble about what to include and exclude in the calculation. What about jewelry? And art? The Beanie Baby collection?!? I like to stick with property, cash, and investments, but whatever you decide to use, be consistent. See my formula here.
4. Determine your risk tolerance.
Harnessing the power of the internet in a different way, take a quiz to determine how comfortable you are in taking calculated risks with your investment portfolio.
Here are a few resources to help you with this task:
- Vanguard – Investor Questionnaire
- Merril Lynch – Risk Tolerance Evaluator
- Yahoo – What is my Risk Tolerance?
- Wells Fargo – Risk Tolerance Quiz
- Index Fund Advisors – Risk Capacity Survey
Use the answers to determine a ratio between stocks and bonds for your portfolio. The quizzes are a guide. Some people use a simple formula, such as “age in bonds” (70% stocks / 30% bonds for a 30-year old) or a more aggressive version, i.e. “age minus 10” in bonds or “age minus 20” in bonds.
When breaking down your portfolio into two broad categories, the “stocks” allocation includes US and International Stock funds, and alternatives such as REIT (Real Estate Investment). The “bonds” portion includes fixed income vehicles including bonds, CDs, and cash.
I have set mine as 90% stocks / 10% bonds for now, but please you do what works for you.
5. Decide if you want international stock and bond exposure.
Depending on which part of the world you are reading this from, this is a very important point. The aforementioned John Bogle of Vanguard fame has stated that international funds are not a necessity in the average investor’s portfolio. Interestingly, Vanguard’s target date funds recently increased the international portion of its target date and all-in-one funds to 40% in 2015.
While it is true that many American companies do substantial business overseas, and owning them gives you some international exposure, there are some very large corporations based outside of the United States, particularly in developed markets throughout Europe and Asia.
Recommendations for international allocations range from 0% to 40% or more. Being in Australia I’ve decided to allocate 30% of my portfolio to international stocks, or 35% of my stock allocation. What this simply means is I keep an eye on Aussie companies more than international ones, but like i said based on where you are investing from you can play around with this.
6. Decide if you want Real Estate Investment Trust (REIT) exposure.
Ownership in an REIT or a fund of REITs is a way to profit from real estate without the hassles of managing rental property yourself. It’s also a good way to diversify your portfolio. While there is some correlation with the overall stock market, over the long term, it tends to be rather low, at least according to this article from Financial Advisor Magazine.
If buying, renting, and selling actual real estate is part of your “investment” plan, I suppose you should determine how that’s going to work at this point. I’m not going to speak much to that, as it is not my area of expertise, and I consider that to be a form of part-time or full-time work more than an investment. This post is designed to help you create a simple, hands-off DIY investment plan. Landlording is not a part of that plan.
I’ve chosen to allocate 10% of my portfolio to Vanguard’s REIT index (VGSLX), although it has come to my attention about 3.6% of Vanguard’s Total Stock Market Index (VTSAX) and 16.4% of their Small Cap Value Index Fund is in REIT, so my exposure actually exceeds 10%.
For further reading on asset allocation, check out the Bogleheads lazy porfolios, including the three-fund and four-fund portfolios.
At this point, you should have your target asset allocation nailed down. You’ve got mine, too (50% Aus stock, 30% international stock, 10% REIT, 10% bond).
7. Learn about tax-efficiency.
Alrighty! you’ve got your very own asset allocation. Now keep in mind that you will have multiple retirement and non-retirement (taxable / brokerage) accounts. You aren’t going to try to recreate your desired allocation in each account. You will apply the asset allocation across all accounts. Understanding how tax works on investments should be your next task (and it’s a tough one but doable).
Tax-efficient fund placement describes a manner in which your assets are placed in the accounts which will provide the best (or least deleterious) tax consequence. Tax-inefficient assets that would be taxed the most are sheltered in a tax-deferred or tax-free (Roth) retirement account.
Tax-inefficient funds include REIT funds, actively managed mutual funds with high turnover, and high-yield bond funds.
The most tax-efficient funds will be ideal choices for a taxable account. These include municipal bond funds, passive stock index mutual funds, and international stock funds with low turnover (index funds). Including tax managed funds such as municipal bonds in a tax sheltered account can be counterproductive. You are sacrificing yield for a tax benefit that won’t be fully realized.
International funds will generate a foreign tax credit that you can report to your country’s tax authority. Growth funds tend to be more tax efficient than value funds, due to lower dividend payments.
8. Start a taxable account.
A taxable account sounds like a bad idea, much like spinal anesthesia, but like spinal anesthesia, it is a good option associated with a scary word.
Also referred to as a brokerage account, or after-tax account, this is simply a collection of investments you buy with money left over after you’ve exhausted your tax-advantaged options.
Although dividends and capital gains in this account can be subject to taxes, there are good ways (keep taxable income low) and bad ways (death) to minimise or completely avoid those taxes. If you are paying taxes on them, they won’t hurt you that badly. Australia has a high-tax rate and so the tax drag on my taxable account in the accumulation phase is also high per year.
If you were paying attention in Step 7, you will fill your taxable account with passive index funds, including international funds if you chose to include them in your portfolio. Municipal bond funds can be a good option too, especially if you can find one that is also tax-free in your country.
9. Sweat the Details
If you’ve followed the first 8 steps, you’ve probably come across some recommendations in your reading that you’d like to implement in your portfolio. You’ve got a plan that will allow you to be a successful DIY investor, but there is some fine tuning you’d like to enact.
Now is the time to do that. Slice and dice. Implement a small value tilt in your local stocks or an emerging market tilt in international. Plan for future tax-loss harvesting in your taxable account. Weigh the merits of various fixed income options like CDs, TIPS, I Bonds, and bond index funds. These details aren’t going to make or break you, but you want to have a plan, and this is your opportunity to make it your own. So do not rush this process, take your time because this investement is for a lifetime essentially so do sweat the small stuff, do not just breeze through.
10. Allocate up to 5% of your portfolio to “play money”
Index investing is boring. You’re not going to hit any home runs or beat the indexes. Of course, you will get market returns, which is better than most active managers do, as Boglehead Larry Swedrroe demonstrates in Swedroe: Active Funds Whiff Again.
But you want that home run, i mean who doesn’t right. You want to pick stocks; and you want to invest in the healthcare sector because you hear and see that pharmaceuticals make a killing. You want to be an angel investor. Or want to own part of a big company like Facebook or Apple. Or a restaurant or distillery (anyone say Gin?).
These investments may offer a higher reward, but the potential reward is often paired with a side of equal or higher risk. A common recommendation is to limit these investments to 5% of your portfolio. If you have a basket of many individual stocks that is reasonably diversified, you don’t have to count that as part of your play money. Doubling down on biotech is another story. Have fun but don’t bet the microbe farm. With the Covid 19 pandemic right now everyone is throwing money at the possibility of a vaccine, keep your ear to the streets but prepare to risk big!
So those 10 tips are what I know, trust me there is more but that is a good place to start. These are the very very basics as far as I am concerend, but have fun with it.
Maintaining the plan simply means making the required contributions each year, purchasing additional shares (or investment properties) as needed, and rebalancing the account from time to time, usually with new purchases.
Once you have a reasonable investment plan, the most important thing, perhaps just as important as your savings rate and far more important than your asset allocation, is sticking with the plan through thick and thin over decades, yes I said decades. No plan will work if you cannot stick with it.
Share with us any questions or suggestions/additions in the comments section. Or if you need any specific topic covered on investment. As always, hope you and yours are safe.
DISCLAIMER: #Teamknowyourpurpose is not a registered investment, legal or tax advisor or a broker/dealer. Instead, the information they provide is based on what the owner of the site has personally experienced. Use at your own risk and seek appropriate assistance where needed.