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Keep It Simple and serve on investment committees all over the world—and we are both glad we index. Most professional investors index a substantial share of their equity and bond portfolios because indexing provides broad diversification at low cost with tax efficiency. Use index funds for all your long-term investments. With index funds, you don’t get average performance. You get above-average performance because index funds have lower expense charges and avoid most unnecessary costs and unnecessary taxes. Later in this chapter, we will recommend the specific funds you could consider. 9. Focus on major investment categories. Avoid “exotics” like venture capital, private equity, and hedge funds. We believe you should focus on three simple investment categories: (1) common stocks, which represent ownership interests in manufacturing and service-oriented companies; (2) bonds, which are IOUs of governments, government agencies, and corporations; and (3) real estate, which can best be acquired through your ownership of your own single-family house. 103 c05.indd 103 11/3/09 10:16:21 AM The Elements of Investing We know that salespeople will regale you with fascinating stories about how certain exotic investments such as hedge funds, commodities, private equity, or venture capital can make you rich, even quickly. Do not listen. Sure, fascinating stories appear in the media from time to time about spectacular profits being made, but here are four good reasons for urging abstinence: 1. Only the very best performers in each exotic category achieve great results. 2. The records of the average performers are discouraging, and those in the third and fourth quartiles can be deeply disappointing. 3. The best performers are already fully booked and are not accepting new investors. 4. If you have not already established a clearly preferential position as an investor, your chances of investing with the best are, realistically, zero. If you don’t own a large private jet, hobnob with movie stars, and know your way around 104 c05.indd 104 11/3/09 10:16:21 AM Keep It Simple unusually well, then you can—and should— ignore the exotics. They’re not for you or for either of us. Beware! If you look hard enough to find a manager who will assure you that he will do great things for you in one of the exotics, you will find him, but don’t even begin to think that the promise will actually be fulfilled. ASSET ALLOCATION The appropriate allocation for individual investors depends upon a few key factors. The primary factor is age. If you have lots of time to ride out the ups and downs of the market, you can afford a large allocation to common stocks. If you are retired, it’s wise to invest conservatively. Another factor is your financial situation. A widow in ill health, who is unable to work and who counts on her investments to cover her living expenses, will not want to risk losing substantial amounts of capital during a stock market downturn. She has neither the time horizon nor the earnings from employment to ride out a major market setback. The third big factor is your temperament. Some people simply can’t stand to experience wide swings in their net worth and will want to overweight bonds and 105 c05.indd 105 11/3/09 10:16:21 AM The Elements of Investing cash reserves in their portfolios. Other people care more about long-term growth. To each his own—with caution. Know thyself and match your investing to who you are and where you are in life. Know thyself and match your investing to who you are and where you are in life. Thousands of people go skiing on a typical winter’s day, and almost all of them have a wonderful time skiing at their own level on the trails and slopes that are right for them. The secret to success and enjoyment in so many parts of life is to know your capabilities and stay within them. Similarly, the key to success in investing is to know yourself and invest within your investing capabilities and within your emotional capacities. No asset allocation will fit all 30-year-olds, 50-yearolds, or 80-year-olds. Even an 80-year-old might want an asset allocation more suitable for a 30-year-old if she plans to leave most of her estate to her children or grandchildren. The appropriate allocation for those planning bequests should be geared to the age of the recipient, not the age of the donor, for that part of their total investments. 106 c05.indd 106 11/3/09 10:16:21 AM Keep It Simple The key to success in investing is to invest with the asset mix that’s best for you, considering: • Your financial situation: assets, income, and savings—now and in the future. • Your age. • Your emotional strengths—particularly at market highs and market lows—and your attitude toward market risk. • Your knowledge of and interest in investing. ASSET ALLOCATION RANGES Now let’s get down to the specifics. Assuming you have already set up your cash reserve, we present our asset allocation guidelines next as reasonable age-related ranges. They will make sense for 90 percent of all investors. Individual circumstances and investment skills and emotional strengths could make allocations outside these ranges appropriate for you, but even so, this is where to start. We also recommend that you own your house if you can afford to do so. The main reason is to enhance the quality of your living. But putting some of your money into a single-family home will also give you a real estate 107 c05.indd 107 11/3/09 10:16:21 AM The Elements of Investing investment in addition to the stocks and bonds in your savings retirement plan. Our asset allocation guidelines . . . show how you might wisely change your asset mix according to your age and your age-related tolerance for market risks. Here are two tables that show how you might wisely change your asset mix according to your age and your age-related tolerance for market risks. The first table shows what Burt advises. We both agree that this pattern is sensibly conservative for most investors. Charley worries that it may be too conservative and offers an alternative, on page 109, with more exposure to stocks and thus to market volatility. Burt’s Allocation Ranges for Different Age Groups Age Group 20–30s 40–50s 60s 70s 80s and beyond Percent in Stocks Percent in Bonds 75–90 65–75 45–65 35–50 20–40 25–10 35–25 55–35 65–50 80–60 108 c05.indd 108 11/3/09 10:16:21 AM Keep It Simple Charley’s Allocation Ranges for Different Age Groups Age Group 20–30s 40s 50s 60s 70s 80s and beyond Percent in Stocks Percent in Bonds 100 85–100 65–90 60–80 40–60 30–50 0 15–0 35–10 40–20 60–40 70–50 Charley’s recommended portfolio mix aims for a higher rate of return over the long term, but depends crucially on an investor’s short-term staying power because bad markets are sure to come again and again. Charley points out that most young people don’t count their most important “equity”— their personal knowledge capital and the large present value of their future earnings from work. Burt notes that we can also lose our jobs. Both agree strongly that all investors are better safe than sorry and that no investor should take on risks outside his or her comfort zone. Charley’s allocations to stocks assume indexing, as do Burt’s. We need to emphasize again that the allocation you choose depends critically on your emotional ability to accept big swings in the market value of your portfolio. 109 c05.indd 109 11/3/09 10:16:21 AM The Elements of Investing Not even your psychiatrist can tell you the proper allocation. If you go toward the 100 percent allocation to common stock investment, as Charley would recommend for young savers, you must be prepared to accept that at times your 401(k) will look like a 301(k) or even a 201(k) when stocks fall sharply. If you can accept that kind of volatility, that’s fine. But Burt, who spends a lot of time counseling young faculty members at Princeton, knows how tough it is to see the value of your savings shrink, and that is why he tends to recommend a lower allocation to equities. For those who are most comfortable with year-toyear market fluctuations, Charley would even favor 100 percent in stocks for younger investors, which is what he is glad he did (and kept doing even in to his early seventies). Taking on more market risk by increasing the proportion of stocks in your portfolio will probably result in your earning a greater long-run rate of return. (It could also result in lots more sleepless nights.) If you are not sure you can live with and live all the way through the worst market turbulence, don’t take on extra market risk. In the “eat well” versus “sleep well” trade-off, reduce your stock percentage to the level where you know, given who you really are, that you will sleep well. 110 c05.indd 110 11/3/09 10:16:21 AM Keep It Simple Put your long-term investments into low-cost index funds. The best choice for your equity investments is a fund indexed to the total world stock market. If you are truly uncomfortable investing in “foreign” stocks, you could choose a domestic total stock market fund. We recommend that you be diversified internationally because the United States represents less than half of the world’s economic activity and stock market capitalization. For your bonds, choose a total U.S. bond market index fund. As you get older, change the mix toward bond investments as the tables indicate. You can usually accomplish this rather easily by changing the allocation of the annual contribution to your 401(k) plan. If adjusting new allocations is insufficient, you could gradually shift some of your existing assets from stocks to bonds. Once a year, rebalance your portfolio to the stock–bond balance that is right for you. Suppose your preferred allocation is 60 percent stocks and 40 percent bonds, but an exuberant stock market has pushed the equity allocation to 70 percent. Take some of the equity gains off the table and restore your 60–40 balance. (Or, if a punishing bear market reduced the equity proportion to 50 percent, sell some bonds and buy more stocks.) If you 111 c05.indd 111 11/3/09 10:16:21 AM The Elements of Investing have other investments, be sure to do your rebalancing in the tax-sheltered part of your portfolio—your 401(k) or IRA—so you will avoid paying capital gains taxes. INVESTING IN RETIREMENT We recommend a substantial allocation to bonds for investors in retirement because bonds provide a relatively steady source of income for living expenses. Some common stocks, however, are included to provide inflation protection and some TIPS (Treasury inflation protection bonds) are included in a total bond market index fund. The interest paid on TIPS is augmented during periods when the rate of inflation rises, so retirees can expect increases in income during inflationary periods. Remember the important exception: If you are fortunate enough to have enough capital to be able to meet your living expenses without tapping into your assets, you can choose a different asset allocation more heavily weighted to stocks. Money that you expect to leave to children and grandchildren should be invested according to their age, not yours. Most people, however, will be drawing down their savings during retirement. They will be faced with a 112 c05.indd 112 11/3/09 10:16:21 AM