Ask the grumpies: How do you approach diversification?

Ali asks:

We are good savers but I fear not great investors (i.e., I have a good bit just sitting in the bank now because I don’t know what to do). How do you approach diversification?

Disclaimer:  We are not professional anything except academics.  Consult with a fee-only financial planner with fiduciary responsibility and/or do your own research prior to making major decisions about your money.

If you don’t know what to do and your money is just sitting in savings, the easiest thing to do is to pick out a retirement date (or house purchase date or whatever) and buy some of Vanguard’s target date fund for that year.  It will take care of diversification for you both right now and over time and you’re done.  (You can also mimic it on your own by purchasing the major indices in it.  Mimicking it will save you some money early on (far from the target date) when there’s not much movement because you’re not actually doing much rebalancing early on– you’re mostly in stocks.  It is still better just to buy the target date than to leave it in the bank trying to figure out how to mimic.)

Here’s #1’s original post about how she decided on percents in her retirement account.  They’re probably a bit conservative (too bond-heavy) for when she was younger, but are more appropriate now.  But #1 wasn’t trying to optimize– diversification isn’t about optimization, it’s about getting decent returns while still staying safe.  In fact,  diversification will always return lower than some subset of undiversified portfolios (it will do better than another subset though!).

Let’s step back a little bit an think about why we diversify.

Diversification is all about moderating risks.  We put some money in stocks, which are high risk/high return and some money in bonds which are lower risk/lower return because bonds keep their value in downturns while stocks are likely to lose value (but stocks shoot up high in up-turns while bonds… keep their value).  We keep some money in cash in the bank because it keeps its value and can be drawn on quickly in an emergency.  In general, we want money that we will draw on decades from now to be in stocks and money we will draw on within the next 5 years in something more accessible like cash or bonds.  The closer you get to your target date, be it retirement or buying a house or starting college payments, the more safe and accessible you want your money to be (with some disclaimers for college savings as where those are put can affect financial aid).

More advanced asset allocation will have you thinking about blue chips vs. tech stocks or emerging markets and international markets.  But the thing is, if you’re at the point where you’re not sure what to do with your money, you can just ignore these.  International stock indices tend to have higher fees.  If you get a broad-based index fund it will already include blue chips and tech stocks.  If you get a target-date fund, it will most likely include emerging markets and international markets in addition to bonds.

Diversification can also hide money from creditors like colleges or debt collectors.  Your primary residence has certain safety threshholds depending on where you live, but it can also be taken away if you use it to secure debt (as with a mortgage).  Your retirement savings is often protected.  Trusts and companies are other ways of protecting assets.

So… I recommend some thought exercises.

1.  Do you have an emergency fund that can cover reasonable emergencies (ex. water heater explosions, a delayed reimbursement, etc.) until your next paycheck?  That should be your first priority.

2.  Are you investing up to the match in your employment retirement account?  If you have low-fee options, put it in a target-date fund.  If you don’t, then compare the fees for the different index funds and pick a broad-based fund (if all things are equal, try to get one that matches the total market or the Russell 5000, but if the cheapest fund is the S&P 500 get that, and it’ll be ok).  For additional retirement savings it’s all about your employer fees and whether you qualify for an IRA and if you want to do a backdoor IRA.

3.  What are you doing about housing?  How much of your house is your net worth?  Do you want to buy a house in the future?  If you already own a house, how accessible is the money in case of an emergency (ex. having to move and the house not selling right away)?  For many people, the house is their main form of retirement saving besides Social Security, but in terms of diversification, this is not a great idea.  On average real estate goes up at the rate of the markets, but that’s the average– owning a single home doesn’t give you the average (it is the opposite of diversification).  If your housing market drops, you could lose a lot of savings (of course, it can go the other direction as well– we have friends in California who bought in 2008 and have gained a million dollars on paper since then).  So try not to invest so much in a house that having the market crash could devastate you.  Note though that whether or not you think it is ok to foreclose should also guide how much you’re willing to have in housing mortgage debt vs. equity (vs. renting).  In general, we do not recommend home-ownership unless you can put 20% down– yes lots of people manage ok putting less down, but lots of people were also put in bad situations having to short-sell or foreclose during the last housing crisis.  Basically, think about the worse case scenario and what would happen.

4.  When do you need the money that’s sitting in your bank account wanting to be invested?  If it’s less than 5 years, you can leave it there, or put it in cd ladders.  If it’s more than that, think about your time horizon–   are you investing for college?  Use a 529 (put it in one of their target-date funds).  Are you investing for retirement?  Use a target-date fund (or read some bogleheads forum about people in your situation).  Are you planning on buying a house in 8 years? Put it in a taxable mixture of stocks and bonds (what mix?  depends on how flexible your plans are given the vagaries of the market– to be honest, we just put it in the S&P 500 and cds as we got closer.)

Always do a mental run about what you expect on average to happen and what will happen in a reasonable worst case scenario (ex. 2008 stock market drop plus job loss, keeping in mind that the stock market increased before the drop, so it’s not like it’s 40% off what you put in, but 40% off what you put in plus your gains– the longer you’ve had it in the market, the more money you still have even after the drop).

Because a lot of diversification is about avoiding the low lows even if you miss out on the high highs.

And about acknowledging that long-run risk is different than short-run risk.  In the long-run, stocks will go up more than bonds or savings.  In the short-run, stocks are risky.

Satisficing will get you pretty close to optimizing risk vs. return.  A Vanguard target date fund is probably good enough, and it’s definitely better for long-term investing than just leaving money in a low interest savings account.

Here’s some next stage financial advice. Resources for asset allocation.

Grumpy Nation, how do you approach diversification?

Ask the grumpies: Socially responsible investing

Linda asks:

So many times I read/hear about “greedy corporations” doing bad things, but then I start to think about the following.

Public companies (which are mostly what people mean when they call out corporate greed) are owned by shareholders. The executives of those companies have a responsibility to earn money for those shareholders, which is why so many of these “greedy things” happen: execs make decisions based on the bottom line. (Yeah, those execs are also earning money (a LOT of money) for themselves, as well. They are hired to make money for the company (a.ka. the shareholders) and if they meet the goals/targets for sales, etc. they get lots of money and bonuses. But that’s a sideline here.)

However, just who are these shareholders who are ultimately behind this drive for making profits and increasing the value of their shares? Why…it’s us! We’re the ones putting money in our 401(k)s, 403(b)s, and/or state and private pension funds, which are comprised of shares in these “greedy corporations.” Right?

And if I’m not misunderstanding it…holy hell, isn’t this a moral dilemma for people who care about values and issues, such as the environment, human rights, and social justice? How many of us who say (for example) we abhor Walmart’s employment practices and/or boycott shopping there, are actually shareholders in Walmart? Or if we hate frakking, yet are also shareholders in companies that do so?

Ethical investing is HARD when you have a limited set of funds to choose from. I’ve poured over the prospectuses of my Vanguard 401(k) funds and shut that information away in my brain so I can pretend I don’t know what’s in those funds and that life is all sunshine, blue skies, kittens, and puppies.

Am I totally misunderstanding how my 401(k) works? Or is there really a utopia of steady investment growth for a comfortable retirement (one where I don’t have to live in a box and eat cat food) that doesn’t exploit others?

You would probably be interested in looking into SRIs (Socially Responsible Indices) within your retirement plan.

For the most part though, those of us doing broad-based index investing aren’t paid attention to by companies.  We’re neutral– sinning by omission, not by commission.  We’re not forcing them to change their behavior and we’re not causing them to have the bad behavior.  We’re not the people who move the markets because we’re not paying attention to individual companies.  Yes, we could do better by doing as you say, picking funds that are socially conscious companies and when we do that we miss out on Exxon’s growth or Phillips 66’s dividends.  We could do even better, if we’re wealthy, by buying huge amounts of stock and going to share-holder meetings to make our social justice positions known.  But of course that adds risk, and most of us aren’t that wealthy.

An alternative, of course, is to keep your money in the broad-based indices and invest your extra returns in charities that you care about.

Target Date Funds Primer

There’s a general consensus forming among the economics community (both academic and policy) that low-fee target-date index funds are the way that most people should be investing.  In fact, they should be the default plan in most people’s 401(k) [default means what you end up with if you don’t pick something else].  Obviously people should be able to make their own investment decisions, but for the majority of people who are confused on these topics, a low-fee target-date index fund will best be able to get them where they want to go.

What is an index fund?

An index fund is like a broad based mutual fund that matches a market.  Mutual funds are great because they allow smaller investors to diversify their portfolios.  With an index fund, instead of paying a mutual fund manager hundreds of thousands or even millions of dollars each year to try to beat the market (which, incidentally, fewer than half of them actually do), a computer tracks the market of the index (often the S&P 500 or Russell 5000, but there are many others) and the index value is based on that.  It is a low cost, lower risk, way of matching the market.

Bottom line is:  index funds match whatever market they are indexed to at a smaller expense than a standard mutual fund.

Why low-fee?

Even with an index fund, your returns can be eaten away by fees.  Some companies can use their index funds as money makers– they’re not paying money managers anything but they charge much higher fees than they should.  This is especially likely when your choices for a 401(K) plan are limited.

If your choices are not limited, look very carefully at your options.  If you have several options for index funds that track the same market, go with the company that charges the lowest fees.  Vanguard is the lowest cost for index funds and for target-date index funds.

Ignore things like “returns since inception.”  All index funds have the same returns for the same index– the only difference in “returns since inception” is whether they started (“inception”) when the market was booming (which shows low returns since inception) or the market was busting (which shows high returns since inception).  It’s a meaningless metric.

What is a target date index fund?

A target date index fund is like a mixture of stock and bond index funds that tilts your exposure from stocks to bonds as you get closer to your chosen retirement (target) date.  This is great because you don’t have to rebalance your portfolio.  You don’t have to recalculate your risk every year.  You can just set and forget and your portfolio will be taken care of.

The paradox of choice causes inaction.  Figuring out what stocks to choose and what ratio of stocks and bonds can be overwhelming and can cause you to end up not doing anything at all.  With a target-date index fund all you have to do is pick one number (and you don’t even have to really be correct!) and set up automatic contributions and the company will take care of the rest.  They’ll automatically rebalance as markets change and they will shift your stock exposure into bonds as you need more sure money and less risk in your portfolio.

What date should you choose?  Well, take a guess on what year you’re going to retire and pick the date closest to that.  If you’re in your 20s now, it won’t matter that much if you get it off by 10 or even 20 years because you’ll still be tilted towards stocks and able to recalibrate for a while.  If you’re closer to retirement, then presumably you have a better idea of when you’re going to need to start drawing down those funds.

Another note on fees

If Vanguard (whose target date funds reflect the actual cost of each index they use) is not one of your options, it may be worthwhile to compare the cost of a target-date index fund to matching it with regular index funds yourself.  This is especially true if your target date is a long time from now– a target date fund will be heavily invested in stock indexes and you can set and forget for a while before you have to start shifting into bonds.  Still, if this idea of having to choose your own portfolio intimidates you, it may be worth paying the additional fee for the Target date fund, even if it is more expensive.

For more information, Boston College has put out this handy primerThis pdf has a lot of great graphs and charts showing how target date funds perform under different scenarios, and this booklet provides more detailed information on the topic.