"The stock market is a giant distraction to the business of investing."
Are you interested in learning the secret to investing success? I've got news for you; contrary to popular belief it doesn't involve picking hot stocks, getting into cryptocurrencies, or picking next year's top performing mutual fund. It comes down to asset allocation and asset location.
Financial distractions are everywhere. Headlines in newspapers, articles in magazines, talking heads, and so on and so on and so on. They want us to think that the secret to investing is picking the next top mutual fund or exchange-traded fund. They urge us to trade our accounts to make sure we pick the next hot stock before we miss out. They publish lists of last year's top investment managers (mutual fund managers) because they know many of us will buy those thinking their success will repeat.
The truth is that none of these things will help you achieve a healthy financial life or success with your investments. The main driver of your long term investment returns is your mix of stocks and bonds...your asset allocation.
Your mix of investments is called your asset allocation. That is, the allocation of your money among different types of investments. There are some important considerations that go into what kind of asset allocation is right for you, such as how much you follow financial news (hint: the less you watch the higher your stock allocation can be) because if you have too much exposure to stocks and there is a market downturn, you may be tempted to sell out at the exact wrong time (the media make it sound like the world is ending). So being honest about how it feels when you see the value of your investments drop is important to consider. Another consideration is how much of your money you will need to spend in the next few years. You can't have money sitting in stocks that you will need, because you don't want to run the risk of the market falling right when you need to get your money out.
Your asset allocation is a set percentage of the different investments. For example you could have an asset allocation of 70% stocks, 25% bonds, and 5% cash. Or, you could have an asset allocation that is 50% stocks, 40% bonds, and 10% cash. The factors above dictate what your asset allocation will be, but once it's set, then you have a policy. You will always keep your investments at this asset allocation (unless something changes in your life). Sticking to this policy keeps things easy and helps keep you from getting distracted.
In addition to the stock/bond/cash allocation, stocks can further be divided. Your stocks can be broken out into big companies, small companies, companies in the United States, foreign companies in developed countries, foreign companies in emerging markets, and so on. The same rule applies; once you know which percentage of your money will go into each sub type of investment, you keep it that way. In other words, if your asset allocation calls for 10% of your money to be invested in small U.S. companies, then you keep it that way (again, unless something in your life changes). You don't want to keep "chasing performance" and having an asset allocations helps you stay disciplined.
The same is true of bond investments. You can split your bond investments into bonds that mature pretty soon, bonds that don't mature for a long time, bonds that are issued by governments, bonds that are issued by corporations, bonds that are high quality (like a borrower with a high credit score), bonds that are lower quality (sometimes called junk bonds, kind of like a borrower with a low credit score), and foreign bonds.
The magic of asset allocation because of something called rebalancing. Over time, different types of investments perform differently from one another. After one year, the amount you have in each type of investment will have changed. Some will have went up higher than others (or went down less). Rebalancing is when you sell the investments that have grown to a bigger percentage and you buy investments that have fallen to a lower percentage. Said another way, you sell the investment winners and you buy the investment losers. This is the magic; you get to buy low and sell high - over and over again - WITHOUT making any predictions about the future.
I do have to mention that this is WAY easier said than done. Remember, this process means you have to sell investments that have done well. Many people struggle with this. "Why would I sell the only investments that have done anything for me?" To add insult to injury, you have to turn around and use that money to buy the dogs, the investments that have sucked over the last year or two. This can be very hard to do, but it's worth it.
Sometimes you will sit down and rebalance your entire portfolio (all your investments) back to your targets, but it can be done with less work. If you are a saver, meaning you haven't retired yet and are putting money away, consider putting your new money into the most underweight investments - that is the dogs. If you are retired and living on your investments, consider selling the investments that are the most overweight, or the high fliers (FYI, there are some tax considerations with this strategy).
The second tool you can use is called asset location, which is a process that determines in which account each of your investments should go. This helps save money in taxes over the long run. For example, bond investments pay interest and that interest is typically taxed at ordinary income tax rates. By putting these investments in tax advantaged accounts you don't have to pay tax on that interest. On the other hand, many stocks pay dividends and dividends are taxed at preferential tax rates. In addition, you have control over the capital gains taxes you pay because you dictate when to sell those stocks.
Allocation and Location Together
Taken together, an asset allocation and asset location policy will help you get to where you want to go, without making predictions, without having to stress about what your investments are going to do, and without paying too much in taxes. There is one minor complication, and that is that rebalancing can be more difficult when different investments are in different accounts. That doesn't mean that it doesn't work, though, it just means that you have to spend a little bit more time when rebalancing.
Letting your money work for you and not getting distracted by what the stock markets are doing is good money health.
Roger Gibson: Asset Allocation
Richard Ferri: All About Asset Allocation
William Bernstein: The Intelligent Asset Allocator
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