This year saw a sea change in the way I invest. Umm…let me take that back. This year I finally decided to put in place an investment methodology. Something that will hopefully form the basis for the way I invest long into the future. I put some thought into it and so in case it might be useful to others, here it is. Needless to say, this is what works for me. Your context may be completely different and what works for you might be completely different (do leave a comment if you think it adds to the discussion).
The most important factor in getting a good return on your portfolio is to be invested. Leaving cash in a checking account just because you haven’t decided what to do with it, or because you are just too lazy to do some research to figure out where to invest it, can significantly erode your returns in a good year. This doesn’t mean that you can’t plan to have some part of your portfolio in cash, if that is what you intended for the cash. But if your year-end bonus comes in and sits in your bank account for 6 months before you even transfer it to the brokerage account or open a CD, that’s like overpaying for your flat screen TV at a retail store instead of buying it from Costco (I’ll bet that got your attention. For more on us cheap Indians search for Russell Peters on You Tube.)
How to allocate your money between different asset classes – stocks, bonds, real estate, commodities – is a serious, higher order question that must be answered first. The world changed for many of us in the second half of 2008. The stock market, we learnt, can be a very fickle asset class. But it is also true that many major asset classes turned out to be terribly correlated. Even so, think hard about your goals in managing your money and then decide on the right asset allocation. I have 40% of my portfolio into fixed income. Investing in bonds has become a lot simpler via ETFs and so there’s no excuse to not following a prudent asset allocation strategy.
ETFs vs mutual funds vs individual stocks
You are deceiving yourself if you think you can pick stocks to beat the index. The boasts that you and your friends make over lunch on how much money they made on Apple or Google will generally miss the important detail that you made a 200% gain on one stock which was less than 5% of your portfolio. The lunch table chatter will never be about how much money you lost on that dog that you invested in last year because you didn’t think it could go any lower. Face reality, you aren’t a stock picker. You’re just giving in to that gambling streak in you. Don’t bet your family’s future on the casino. If you must bet on individual stocks, set aside some play money to indulge yourself.
Investing in mutual funds is better but it is still a mug’s game. Do you know anybody who can beat the market consistently? I have spent a lot of time with smart money managers and I can’t say that I have. Not because the people I met weren’t smart. It’s just that beating the index consistently is just too, too difficult. Especially, net of fees. Read this if you need some convincing.
The reason I love ETFs is because they give me diversification with very low fees. And with the proliferation of ETFs, you have a vast array of investment options – stocks, bonds, commodities, different markets, even leveraged bets and shorting the index. Passively managed index funds are similar in nature though they don’t have as wide a variety.
For asset classes other than stocks, ETFs are even more compelling. ETFs are traded on a stock exchange. They are very liquid and you know what they are worth at all times. Owning bonds or commodities used to be much more involved in the past. ETFs make dead simple. ETFs also allow you to easily allocate a part of your portfolio to international markets. Owning individual international stocks or bonds is much tougher.
I have great faith in emerging markets. They will be volatile, but the long-term fundamentals are good. You can get emerging market exposure in both stocks and bonds. You can go by market or buy into all emerging markets with something like EEM. I also own EMB which is an emerging market bond ETF.
Your broker – online or full-service is typically not going to have the tools to measure how you are doing except for the simplest of situations. I have never quite understood why. The computation and the tools required are pretty trivial. Is there like a platinum level of membership with Schwab where these tools get unlocked?
In the meanwhile, I pull down the data and compute my own XIRR. I always choose to reinvest dividends, which helps keep the computation simpler. It can get a little messy if you accumulate over time and then sell over time. But since you are doing this for yourself all you need to know if your investment is meeting the criteria you set for it or not.
I can’t say that I have a long track record of disciplined investing. But in just this year, there has been enough temptation to break my asset allocation rules. The US markets kept climbing and here I was stuck with a self-imposed 40% allocation to bonds. But I held fast and I plan to stick it out in the future as well. Changing your asset allocation in response to an attractive investment option is exactly the kind of thing that gets you in trouble. You don’t have the dampeners in place when an asset bubble bursts.
That doesn’t mean you can’t change your asset allocation or investment strategies. But it should be done as a long-term shift in strategy rather than to spike returns in the short-term.
Next year it’s going to be tough to make a decent return in almost anything. It’ll be a good test for my new investment methodology.
In the meanwhile, I hope you find this useful. Again, I don’t mean for this to be investment advice. What will work for you depends entirely on your context.