Lesson five: figuring out what to invest in
Once I realized 401(k)s and Roth IRAs were just accounts, not investments, the next step was to figure out what exactly to invest in.
This was confusing because it seemed as though there were dozens of different recommendations. Invest in [insert hot stock]! It’s only going to go up! Maybe I should invest in a few different tech companies? I thought. Everyone is always talking about Tesla, Amazon, Google, and the others.
Eventually, I stumbled upon Bogleheads. Bogleheads is an investing philosophy inspired by John "Jack" Bogle, the founder of Vanguard. Bogle popularized index fund investing. He created the world’s first retail index mutual fund.
Instead of individual stock picking, you would invest in the total stock market. Over the long run, low fee index fund investing has beaten more expensive actively managed funds and stock pickers a majority of the time.
3-fund portfolio
The Bogleheads philosophy goes through how to build a simple, diversified, low fee investment portfolio that gives solid 8-10% average returns over the long run. A way they do this is utilizing a three-fund portfolio.
Total U.S. Stock Market Fund
Total International Stock Market Fund
Total Bond Market Fund
Let’s see how a three-fund portfolio could be built using Fidelity funds.
Target Date Index Funds
And there are funds that take this approach and make it even easier for investors: Target date index funds. These are funds that have a “target year” of around when you expect to reach traditional retirement age (age 67). The target years come in five year increments (2055, 2060, 2065, etc).
Example: Someone born in 1997 may choose a Target Date Index 2065 Fund since that is around when they turn 65-70.
A great thing about these funds is they handle the rebalancing for you. Since stock values fluctuate in price and grow at different rates, your asset allocation can start to drift from your preferences.
Your 65% U.S. Stock, 25% International Stock, 10% U.S. Bonds will start to drift away from those percentages. The fix to this is to go into your investment account once or twice a year and buy/sell some of your holdings to get back to your desired asset allocation.
“Uh, what?” you’re probably thinking.
Yeah, that was my thought when I wanted to start investing. “That sounds complicated. I just want to contribute money into the account and have it do its thing”
That’s the beauty of Target Date Index Funds. They do that work for you!
A criticism of target date index funds is how they may be too conservative for investors. Some people believe that due to the low returns of bonds, younger investors (those under 50) shouldn’t have any bonds. There are also lots of opinions on the % allocations of U.S. Stock and International Stock.
One way to have a more aggressive portfolio, and not include higher than a 10% bond allocation, is to choose a Target Date Index Fund that is around when you turn 70-75.
Robo-advisors
In the quest to simplify investing, a newcomer emerged: robo-advisors. Harnessing the power of automation, these services will create and manage an investment portfolio for you. At a fraction of the cost of a human advisor.
You take a short questionnaire about your age, risk tolerance, and investing goals. The service will give you a recommended portfolio of low fee index funds or ETFs. Then, they will manage the portfolio for you.
These services have exploded in popularity in the past decade. For good reason. I mean…most people are salivating at the mouth about the idea of managing investments. They know they should be doing it, but it confuses them and frankly, they have other things they want to do with their time.
Two popular robo-advisors are Wealthfront and Betterment. We will talk more about them in the next lesson.
Wrapping up
So for those new to investing, there are the three simple options for choosing funds:
3 fund portfolio (Bogleheads)
Target date index fund (3 fund portfolio managed by an investment fund manager)
Handing it off to a robo-advisor (think of it as a more customizable target date fund)