Investments for Every Temperament
What to do with your savings
by Scott Teresi
What should you do with your savings? If you’ve got a couple thousand dollars buried in a jar behind the tool shed, dig it up and invest it already! At least this will prevent inflation from eating away at it. ($100 sure was a lot in 1970.)
There are investments which are appropriate for just about everyone’s situation, no matter what your risk level or how interested you are in money. Make your savings do a little work. Consult the chart below to get started or contact me if you have questions. For best results, mix and match a few categories with what you feel comfortable with! If you get into the Higher Risk investments, it’s very important to diversify because there’s no sure thingread more below.
Investments for Every Temperament!
Insured by the government
(I personally avoid most of these and skip to Medium Risk below.)
Stick your money in a savings account and just forget about it, you lazy investor! Go ahead, let inflation eat away at your capital!
Certificate of Deposit
Go to your bank and buy a 1- to 2-year Certificate of Deposit. Or check BankRate for banks selling ones with higher rates. CD’s start at as little as $500 or $1000.
1-yr. CD currently earns: 1.5% (Apr. 2010)
If you feel interest rates have stopped going up or are headed down (check here), buy a 5-year CD if you can to lock in a good rate. (Note: Taking out money before the end of the 5-year term forfeits some interest.)
5-yr. CD currently earns: 3.25% (Apr. 2010)
TreasuryDirect.gov offers many types of federally-insured investments, such as savings bonds, I-Bonds, TIPS, T-Bills, and Notes! Most of these are easier to buy through a diversified mutual fund, which doesn’t lock up your money for years at a time. But you can also spend some time now and then and browse the site to see if anything is being offered at higher rates than CD’s. Also, purchases start with as little as $25 and usually have no fees.
Not FDIC insured, but you won’t lose too much value even during tumultuous times
Most people would do very well to keep most of their savings in a Money Market account rather than a savings or checking account. You can write checks on it like a normal checking account.
When you open a brokerage account (like with Vanguard) and send them money, they store it in a Money Market account for you automatically.
Risk is virtually zero. During the 2008 financial crisis, money market funds were one of the few safe places. You should earn approximately whatever the Fed (Ben Bernanke) has set short-term interest rates at, minus fees. (Money market fees vary widely and are usually way too high, except at a few places like Vanguard and Fidelity.)
Currently earns: 0.1% (Apr. 2010) but will hopefully be rising soon
A Bond Fund
Open an account at Vanguard and buy their Vanguard Total Bond Market index fund. This straight-ahead bond fund holds a broad sampling of high quality long- and short-term U.S. bonds. They will fluctuate a little in value. Total Bond Market’s worst 1-year return was -2.7%, in 1994 (since its 1986 inception).
Earned: 5.9% (ten years to Apr. 2010)
Earned: 7.4% (ten years to Apr. 2010)
Other Bond Funds
Bond funds pay more interest than CD’s or money markets, but their share price (your investment’s value) will fluctuate a bit. Bond prices fall when interest rates rise and vice versa. Longer-term bond funds pay more interest but rise/fall more, so they should not be bought when rates are clearly rising. Rates often rise when the Federal Reserve raises them or when the market predicts inflation down the road.
When bond prices are falling, invest in short-term bonds, such as Vanguard Short-Term Investment Grade Bond Fund. It's extremely stable, often almost as safe as a money market account, and earns a slightly higher percentage. However, during the 2008 financial meltdown, all bond funds lost some money. While previously, this fund's worst loss (since 1982 inception) was -2.2% in 1992, in 2008 the fund dropped -7.6% at its worst. It easily gained that back in less than a year.
Earned: 5.0% (ten years to Apr. 2010)
Compare graphs for long-term returns of bond funds, with dividends included, at Morningstar. Here's the Loomis fund. (Almost all other graphing sites like Yahoo and Google misleadingly exclude dividends.)
Earned: 9.0% (ten years to Apr. 2010)
"Balanced" funds that contain a mix of both stocks and bonds are great for one stop shopping.
They may be too conservative for some young investors unless coupled with one or two other more aggressive funds (see the boxes to the right). That said, if you're investing anything in the stock market, it's important to balance it with at least some bonds, like these two funds do. No one fund is perfect for everyone (and neither of these recommendations below hold enough smallcaps or any international stocks, necessary for diversification).
Here are three fantastic all-weather funds:
Vanguard Wellington is one of the most popular balanced funds. About 35% of the fund is in bonds. If it fits your situation, it's one of the best ($10,000 minimum).
Earned: 7.0% for the ten years to Apr. 2010 (from inception in 1929 through Mar. 2010 it's earned 8.16% annually)
Earned: 10.15% for the ten years to Apr. 2010
Earned: 10.4% for the ten years to Apr. 2010
A professionally-diversified portfolio
Get a financial advisor (watch their fees), or subscribe to a reputable newsletter (most underperform the market). Check Hulbert Interactive (small fee) or the Hulbert Financial Digest at your library for exhaustive rankings of the top newsletters. Only look at those which have been around for at least ten years (a full market cycle). Sign up for a free trial, or try your local library. Take a percentage of your total portfolio, and follow their advice closelythe funds in a portfolio will be designed to work as a team. If you want to reduce your risk, keep some of your money in bonds or a money market account (this amount should range with your age or investment goals).
I believe newsletters provide the right balance between providing you advice (keeping you "in the know" and following a disciplined approach), while still keeping fees low (usually $100-$150 a year). Good newsletters focus on buying top quality fund managers and tailoring their portfolios to the current investment climate. Growth stocks may be better now, but five years later, value stocks may be better. If you never change any of your mutual funds, or if you time the changes incorrectly or too frequently (as most people do) you may be missing out on some wise choices.
One newsletter I recommend is The Independent Adviser for Vanguard Investors. Its audience is anyone saving long term, buying mostly Vanguard mutual funds (for their low fees), and who doesn’t want to trade funds often (buy-and-hold). Like most newsletters, of course, it's a business marketed to the masses, and its author will tend to want to minimize tracking error.
Earned: 4.5% (ten years to Apr. 2010, Hulbert Financial Digest)
Earned: 5.5% (ten years to Apr. 2010, Hulbert Financial Digest)
Choose your own funds
With some concerted effort, you can try to choose your own funds with good long-term performance. Money magazine often rates the best funds, but they’re always changing! Subscribe to Morningstar and read their Analyst Report for any fund before investing. Check their top funds (looking at 10-year returns) or the discussion forums for ideas.
How do you settle on a fund for the long term? Pick good managers, low fees, and as high a risk as you can stand. With few exceptions, make sure you diversify among largecap and smallcap, value and growth, domestic and international companies, and always have some bonds. To really do well with mutual funds, I’d say look at the next box to the left. But as of 2007, I have a couple core funds that I would recommend for almost anyone who wants to roll their own retirement portfolio. These are run by excellent managers with long term track records:
Vanguard Primecap Core or Primecap Odyssey Growth. Similar to a couple of Vanguard’s most successful long-term funds. From Morningstar: "The team uses a sensible, contrarian growth style that allows the fund to participate in high-growth companies without paying up as much as its rivals. It also tends to hold its picks for the long-term." For more risk and return, try Primecap Odyssey Aggressive Growth, a midcap fund, or the more largecap Vanguard Capital Opportunity fund. All of these are run by the same excellent management company.
FUNDX: The FundX Upgrader fund is as close to one-stop shopping as you can get. Using the NoLoad Fund*X newsletter's performance as a proxy (see box at left; they're run very similarly), it has outperformed most any other diversified portfolio strategy, going back to 1980 (see Hulbert's rankings). It's a momentum-based go-anywhere fund: it can own small/largecaps, emerging markets, growth/value, etc. depending on prevaling conditions. However, its yearly fee is very high at 1%, considering it just owns a collection of other funds (which all charge an average of 0.9% themselves).
Finally, an essential step: type in all the funds you own into Morningstar Instant X-Ray to see how diversified your entire portfolio is, by asset class. Make sure you have good reasons if you’re overweighted toward growth or value (generally you should be balanced). Make sure to own at least 20-30% international stocks, including some emerging markets. And the more midcaps or any smallcaps you have, the more risky (volatile) your portfolio will be, though your potential gains will be decidedly higher.
How do I start? The first law of investing is to "know and manage the risk of your investments." If you’re a high-flying risk-taker, look at a graph of how much your riskiest investments (like a China mutual fund, or gold fund) have fallen in the past during times like the real estate crash (2008-2009), dot-com bust (2000-2002), or the 70’s crash or the crash in Oct. ’87. Expect this to happen again and again and anticipate how you will behave, knowing that there are no reliable warning signs beforehand.
If you’re a conservative investor at heart, you’re still not off the hook. Look at more risky investments and see how well they performed over long periods (10-20 years) and think about what you’re forgoing. If you have a long time horizon, then avoiding riskier investments like the stock market for at least a minority portion of your portfolio entails another kind of very real riskthat you will not meet your financial goals.
Rational investing is all about managing risk. If you’ve chosen a diversified mix of investments, with a combined amount of risk you’re comfortable with, you should be able to pass the "sleep test"you can sleep well even when the inevitable market events happen! (It’s important not to sell when everyone else is panicking.)
Historically, every class of investments has a propensity toward a certain amount of volatility. For instance, smallcap (small company) stocks rocket up and crash down a lot more than largecap stocks. Smallcaps tend to have higher returns but more volatility. Largecap stocks are in turn more volatile and higher-returning than most types of bonds. Good bonds rarely lose money over a one-year period. Your first question should be: what percentage loss of my total net worth can I tolerate? Allocate some money to stock mutual funds (see above) based on their historical volatility, and then put the rest of your money into bonds, money markets, and safer investments to reduce your risk and prevent your portfolio from suffering a loss you consider too crippling.
It’s virtually impossible to predict which types of investments will go up or down and when. But what you can control is how much exposure you have to the types of investments which are more volatile or less volatile. Use this Vanguard page to decide how much to put into stocks and how much to put into bonds and safer investments. Look at the worst drops of each of your investments and then for your portfolio as a whole.
Enough talk! How do I really start? A brokerage account is all you need for Medium and Higher Risk investments. I recommend Vanguard if you buy any mutual funds (including bond funds) because their funds have the lowest yearly fund fees, they have the highest interest on their money market account (Fidelity is similar), and their phone support is completely top notch. They can walk you through all the details. A minimum mutual fund investment is usually around $2000 or $3000 at Vanguard, but you can probably park as little as $1 in their money market account, earning interest, to start out (and you can write checks on it to withdraw). Sign up through their web site and send them a check. Once you make your first investment, try to continue investing at regular intervalsdiversify by time. You can even do this by setting up monthly direct debits from your checking account.
Vanguard lets you buy Vanguard funds for free, but non-Vanguard funds cost a hefty $35 fee to buy, and $35 to sell. If you want to buy a lot of non-Vanguard funds, I recommend Firstrade or E-Trade. I've never used E-Trade, but they offer full service and have been around a while and have competitive fees at $10 per stock trade and $20 per mutual fund trade. However, they have a stringent $2000 account minimum. Fall below that, and you'll be assessed a $40 quarterly inactivity fee. Firstrade does the job just as well and has the lowest fees for its feature set, at $7 per stock trade and $10 per mutual fund trade. They have no inactivity fee and no minimum balance. All brokers also offer a subset of mutual funds for no transaction fee at all (the catch is that many of those funds have higher annual expense ratios themselves). The industry is getting more competitive, so there may be even cheaper options. Zecco looks interesting.
Use the table above and get started!!
S&P 500 index
an average of
10% per year
After 50 years,
almost 7 times.
the $2000 would
How do I use the table above to get started? To find where you’re most comfortable investing, find where your risk tolerance on the left crosses with your temperament along the top. Start there, but you should never put all your eggs in one basket (if you’re buying any stocks). Deviate outside of the boundaries a little bit (into Medium and Higher Risk boxes), but don’t overdiversify all over the place, and don’t take more risk than you’re prepared to accept if the worst case scenario came true. The best investors always have at least some money in the stock market and some in bonds or CD’s and other investments, even if they only look at their investments once a year. The only question is how much of each do you feel comfortable with?
Consider keeping a reasonable chunk of your savings in a federally-insured investment (the low risk category). Also, don’t tweak your investments more than once or twice a year, or you’ll lose a lot of money in transaction fees, and lose out trying to chase the hottest tips. And finally, if you have any credit card debt, pay this off before making any investments, since you’re probably paying a higher rate than any investment can reliably give you. This site lists "Ten Golden Rules of Investing."
Why should I take a risk? Generally the higher risk an investment is, the better chance there is of it growing fast, but the greater the chance that it could drop steeply in value during a national crisis or unfavorable financial event. Financial crises manage to happen pretty frequently, so don’t put all your money in high-risk investments. Every five or ten years, the overall market seems to drop about 33%. But do put some in (experts recommend 20%-50% in stocks even for the most conservative investors). If history is any indication, the stock market will continue to go up faster than any other investment (see chart below "Average Annual U.S. Stock Market Returns").
How do I know how risky an investment is? The easiest way is the look at a graph (enter the ticker symbol into Yahoo Finance) and see what percentage drops are typical for the fund or stock. You should always look back at least ten years, which usually catches the last major crash. Some funds barely went down during the 2000-2002 bear market (such as many bond funds, and even stock funds like Fairholme and Hussman Strategic Growth; see main table above).
The risk of a mutual fund can actually be quantified using several measures. One of the most popular is called "beta." If the beta of your fund is 1.0, then the fund has the same amount of risk as its benchmark (if it’s a stock mutual fund, that would be the S&P 500 stock market index). If the beta is 1.10, then the fund tends to rise 10% more than the S&P 500 during up markets, and fall 10% more during down markets. You should always consider the risk of an investment before putting money into it. Make sure you can accept the magnitudes of loss which may be likely, as a result of the risk measure. It’s not unusual for the market to drop a lot during the course of any one year. (See the table of average annual stock market returns below, for some typical swings in value.)
Big losses cause several things to happen to your portfolio. 1) They make it much harder to obtain your investment goals. If you lost 25%, you’d have to earn 33% back in order to break even. 2) Having a volatile portfolio and short time horizon is a recipe for disaster: your money may be disappearing at just the moment that you need to cash it in! 3) The psychological aspect is often overlooked by inexperienced investors. It’s important to make infrequent, measured changes to your portfolio, mostly on the basis of rebalancing to maintain your desired allocations and adjusting your long-term risk. If you ever find yourself with the urge to sell your stocks when they go down (as way too many people do), then your portfolio’s volatility may be higher than your comfort level (or you’re watching day-to-day fluctuations too closely).
Why should I pay attention? Generally the more time you spend paying attention to the current economic climate, within reason, the more you can customize your investments to squeeze the most value out of each year that your money is sitting somewhere. The economy evolves (with changing interest rates, inflation, stages of the business cycle, geopolitics) and funds will evolve (new managers take over, the fund grows too large and bogs down, it gets closed to new investors, etc.). Everyone values their time differently. So if you don’t want to spend the time, consider paying someone else to feed you the best intelligence or make the decisions for you. Especially if they’re a professional and do it for a living. (I’ve had great success with my retirement savings by generally following the advice in an investment newsletter, The Independent Adviser for Vanguard Investors. I also recommend the NoLoad Fund*X newsletter.) Of course, you don’t want to micromanage your investments and end up trading too often.
However, it’s easy to invest without worrying about money every day. One reason I made this page was to show how easy it is to increase the money your savings can make for you, with very little attention and time commitment.
How will this affect my taxes? At the end of the year you’ll be sent one or two extra forms from your brokerage company. A 1099-DIV will list all the money you made on dividends (an investment that paid you interest). They’ll also send you a form showing you each time you sold a stock, bond, or mutual fund. As long as you didn’t trade in and out of too many investments, you’ll only have a couple of these transactions to enter into your taxes (on your Schedule D), which is very easy to do. And if all of your transactions took place within an IRA or 401(k), you won’t have anything to report on your taxes at all! (If your investments are more complicated, see a tax advisor.)
What if I want to buy more than one type of investment? Great! Highly recommended! Each type of investment has its own types of risks, and if you buy more than one type, the chance that bad things will happen to all your investment at once is minimized as much as possible. If the stock market crashes and you have some bonds, then your diversification helped save you from a much worst outcome. If you had all your eggs in one basket, your volatility would have been much higher. Let’s say you had 100% of your money in stocks. If you moved 20% of that into bonds, that might only reduce your annual return by 0.22%, while at the same time it reduces your risk (downside losses) by a whopping 20%! (See this article at GMO.com or this Vanguard page comparing the volatility and returns of different percentages of stocks and bonds.)
The first step in buying more than one type of investment is to decide on your asset allocation. This gets into the meat of self-managing a diversified portfolio and is beyond the scope of this introduction. This Investopedia article gets into the nuts and bolts you need to know to set up your asset allocation. This short investment guide goes over some basics also (the "five essentials"). Or try the Morningstar Investing Classroom. To really build a strong foundation, look into some of the books listed on these sites: The Best Books On Fund Investing; The Best Books For Getting Started; and Useful Investment Books. I recommend William J. Bernstein’s books.
How do I keep tabs on the market and my investments? Once you have a feel for things, get periodic market analysis and advice from Morningstar.comto read their analyst reports on any specific mutual fund, sign up for a free 14-day trial, or pay just a month at a time. Post any question, no matter how basic, in the Morningstar discussion forums (which seems to have some of the more courteous people on the net, in my opinion, except the Bogleheads spin-off forum, which is a good place to go for more technical discussions). For advanced research, read the market outlook reports at GMO.com. Keep up to date with blogs like The Big Picture, Seeking Alpha, and John Hussman's Weekly Market Comment. Get daily news from the headlines at MarketWatch.
Some essential tools: Analyze the diversification of your portfolio using the free Instant X-Ray at Morningstar, and graph your funds’ performance at Yahoo Finance or Morningstar (the latter is one of the few free places on the web that can graph total growth, including dividends/distributions).
What else am I missing? There’s tons more to this discussion than what I’ve included here! Good investing also encompasses other components of financial planning, such as purchasing term life insurance if you have someone who depends on you for income (it shouldn’t be used as an "investment") or need to protect yourself from lawsuits, purchasing real estate which will never completely lose its value no matter what the economic climate (and you can live in it too), running a business where other people earn money for you, improving your education, making wise day-to-day purchases and donations, taking a vacation now and then, and planning for life careers and goals. And lots of other things beyond the scope of this page. See CNN’s list of common sense money saving and investment tips.
Time. One of the surest rules in investing is that the majority of the gains of your investment will occur during the last few years of the investment, for instance after it’s grown for 20 or 30 years. See the green table above, "Investing + TIME: An Illustration."
An investment held for a short time returns almost nothing when you compare it to an investment you started when you were young! A typical stock market investment can double every 8 to 12 years (depending on how aggressive you are and if you adjust for inflation). In the table at left, look at how fast a small investment of $2000 is growing by the time the subject is in their 50’s! And it just keeps growing faster after that.
So that’s the surest way I know of to get rich by doing nothing. Invest a good chunk, as early as possible. (Or if you’re already old, start saving for your kids!)
Average Annual U.S. Stock Market Returns
"To illustrate the volatility of stock prices, the following table shows the best, worst, and average annual total returns for the U.S. stock market over various periods as measured by the Standard & Poor’s 500 Index, a widely used barometer of market activity. (Total returns consist of dividend income plus change in market price.)" [From Vanguard’s 500 Index mutual fund prospectus]
The Stock Market’s Four-Year Cycle
Stocks tend to rise the most during a president’s third year in office
During a president’s third year in office (e.g. 2007), stocks have tended to perform magnificently!
I’m not affiliated with any of the companies or funds I’ve recommended above other than owning shares in most of them. Legally, I might have to say this stuff: The content above is not intended to provide individual investment advice and is not based on knowledge of any reader’s individual needs or circumstances. Past returns do not indicate future results. Readers should not assume that any investment will necessarily be profitable or will perform the same as it has in the past. Be sure to read the prospectus before purchasing any mutual fund.
Last updated: April 2010