The year 2024 has proven interesting if nothing else. A return to higher interest rates and better returns in the “income” side of the market. I have always been an equity investor favoring stocks and mutual funds. Now being retired I do have cash reserves in various instruments. Let’s discuss where to store cash.
Cash is relativily easy. You can put it in a safe, your local bank, an online savings, CD or money market account. These options give you liquidity and varing degrees of access. Even with higher rates your local bank is not likely giving up much in interest and still often below 1%.
The highest yeild Online banks are hovering between 4.2% and 4.9% currently (November 2024). These rates will fluxuate with the interest market but the balance is likely FDIC insured. You do give up some access with online banks if you read the fine print it may take 7 days to access your funds.
Money Market funds are currently in line with the online bank returns but you typically need to transfer to cash prior to accessing funds. In a money market fund a fund manager is buying a number of different income type investments trying to get a better yeild. There is no guarantee but since they invest in safe assets there is little risk. The funds are accessible with a sell order and some brokers may let you write checks on the account.
CD’s or Certificate of Deposit. A CD offers a guaranteed rate of return over a specific amount of time with FDIC insurance like a bank account. Rates vary based on the market rate but are locked in at purcahse. The current rate environment has CD’s competing with money market and high yield online bank accounts. CD’s are one of the safest investments and you can build a CD ladder if you need access to cash over time.
A CD ladder is a strategy of buying a number of CD’s with varying maturatity dates. Imagine you wanted to provide a steady cash flow every 6 months. You would buy a 6 month CD, a 12 month, a 18 month etc. That way every 6 months a CD matures and you have access to the cash and interest.
Let’s discuss Bonds. I’ve never been a fan but have been studying. A bond is just a loan to a company or municipality. You get a rate of return (cupon) often paid semi-annually and your principal back at maturity. There is risk, if the company or municipality goes bankrupt, you won’t be paid and that’s where the ratings come in. Credit rating agencys rate bonds for worthyness and therefore risk level.
Bonds can also be sold on the secondary market. If you chose to sell prior to maturity a broker will offer on the market. If newer bond rates have dropped yours is now more valuable and will be worth more. If rates increased no one will want your bond unless it is discounted. The safest bonds are US Treasury bonds. Just buy them and hold to maturity.
As I said in the beginning I’m not a fan of bonds. I never bought a bond until just prior to retirement. I was trying to protect a pool of funds to bridge between my early retirement and age 59 1/2. Well I got caught in one of the rare times both stocks and bonds dropped! Granted the bonds dropped significantly less than my equitys but you never want to loose “safe” money.
So where does all this leave me? My wife and I are both over 59 1/2 so we have penality free access to all accounts https://www.1engineeronfire.com/wp-admin/post.php?post=366&action=edit . If I treat pension money like “income” I’m a 50/50 investor. But just looking at invested capital I still stay 90% stock and 10% cash. This way I can get the high return of the market but have a 3-6 year cash buffer if the market goes South.
This approach takes disipline and perhaps a variable withdrawal strategyhttps://www.1engineeronfire.com/wp-admin/edit.php?tag=retirement if things get rough in the market. I’ve watched a few black Fridays, a few recessions and the COVID-19 event over my 30+ years of investing. I’m confident I’ll stay the course!
1EngineerOnFIRE
EngFI2022
14 Jun, 2024
Posts
I’ve been retired 4 years now and have enjoyed every minute. My wife and I spend more time doing the things we enjoy. I don’t fret over the stock market but I still enjoy keeping tract.
I have done some more research on withdrawal strategies and it seems options are endless. Two and Three bucket strategies, dividend strategies, annuities, auto withdrawals and endless combinations of anything imaginable!
Ideally one would have enough assets to live off the dividends while the stock continues to grow. This would allow you to leave a legacy and never worry about finances. Unfortunately, this strategy requires a nest-egg value unachievable for many Americans.
I like the idea of drawing down stocks when they are up and cash when stocks are down. But I hate having too much cash on the sidelines. My Fidelity advisor suggested I just set my preferred allocation and draw down my assets proportionally. That seems a bit over simplified for my taste.
My Merrill Lynch advisor takes a more cerebral approach to withdrawals. When I ask for funds, he looks at all my holdings, he then only sells stocks that have had a good run and may be overpriced. He recommends only a year or two worth of cash equivalents for downturns.
Key factors to consider include:
Retirement age, pension payments, social security planning, portfolio amount and risk tolerance.
To avoid overcomplicating the issue you need to know your annual income need. Project that over your upcoming life phases (Go go, slow go, no go years). Subtract the guaranteed income from the total need to find the “gap”. Plan your portfolio withdrawals based on the gap amount for each life phase.
Many people will find their withdrawal rate a bit high (>5%) during early retirement and the go-go years. Dropping the withdrawal rate to something more reasonable (3-4%) during the slow go years and finally a drop to a very sustainable rate later in retirement. I’m ultra conservative on my withdrawals and keep them in the 3% range.
Understanding your likely income need is critical for this planning. Apply a comfortable inflation rate, reasonable rate of return and add consider your risk tolerance then you can feel comfortable with your withdrawals.
If your plan issound, it really won’t matter the exact withdrawal strategy. You should be confident in your planning to know you will not outlive your money.
1EngineerOnFIRE
EngFI2022
8 Nov, 2023
Posts
HOW MUCH IS ENOUGH?
Do you even know what Your Enough is?
PROBLEM
Here in the US we are driven to succeed often defined by how much stuff or money we have. How big is your house, what type and how many cars, vacations, toys, etc. I propose we may need to redefine success to allow more people to reach it.
I was never one to keep up with the Joneses as I had my own written goals I was trying to meet. I modified those goals over the years and met them all. But now that I’m retired, all that stuff I worked so hard for seems less important. Could it be my goals were misdirected?
I know people who are so focused on money that every decision they make assures they make more. They unknowingly put relationships at risk by prioritizing making or saving a buck! Sure it’s good to be conscious of your spending but you need to be aware of the total cost.
I’ve seen people who live in very nice homes and have very nice things only to become disappointed and ask “What am I doing wrong that I don’t have that?” when they see a bigger home or fancier car, boat, etc. They clearly don’t know their enough!
FINDING YOUR ENOUGH
What I’ve learned is that having goals is a good thing and keeps one motivated. But make sure your goals are in line what makes YOU happy. You need to find your enough early in your planning or you will find yourself forever looking for more.
I’m finding that time with family and friends, new experiences and meeting new people is way more enjoyable than buying another sports car, boat, motorcycle, etc. I just want to get back to the next adventure. Don’t get me wrong I still enjoy my toys but it’s the experience with friends that makes the difference, not who has the newest and best toy. Keeping up with the Joneses is a fools game.
So how do you find Your Enough? It will be different for everyone but look back over the last year or two. List the 2,3,5… things that made you smile the most or things you can’t wait to do again. Those things are what matter most to you. Build your goals around doing those things. Look carefully at what made them special. If it was a camping trip, I bet time around the grill or campfire was more important than what kind of tent or RV you had.
Perhaps we should redefine success with happiness and things that make us smile. Having a secure lifestyle that brings you joy should be the goal.
CONCLUSION
With this concept in mind you can develop a plan to find your enough and be well on your way to achieving Financial Independence.
1EngineerOnFIRE 1engineeronfire.com
EngFI2022
6 Dec, 2022
Posts
INVESTING IN A DOWN MARKET (November 2022)
The year 2022 has been a tough one for the markets. As I write this article the DOW is -6.65% and the S&P is -15.4% YTD. Not catastrophic numbers but not the double-digit positive returns we all hope for. So, what do you do when the market is down. It depends on your stage as an investor. In its simplest form investing can be thought of as having just two stages, accumulation and distribution. Your actions depend on your investment stage.
ACCUMULATION STAGE
Investors in the accumulation stage are working to reach their retirement goal buy regular investing. They will invest 10-15%, or more, in their 401-k, IRAs or brokerage accounts. The most successful investors automate this process with monthly investments in these plans. (See “Picking the Right Investments” here https://www.1engineeronfire.com/?p=363.) The investor can then focus on their careers, family and friends knowing they have a plan to reach their goals.
In a poor market the investor in the accumulation stage is smart to stay fully invested knowing they are buying shares at low prices and the market will eventually return. The confidence of having a long-term plan and automated investing makes it easy to ignore market downturns. The worst thing the investor can do is pull their funds out of the market and wait for things to improve. History shows they will most certainly sell low and buy high. This locks in their losses and they miss the growth opportunity when the market returns. The saying “It’s not timing the market but time in the market” that really counts.
DISTRIBUTION STAGE
Investors in the distribution stage have more to worry about in a declining market. They have reached their goal of retirement and are regularly withdrawing money from their portfolio to provide income. Different withdrawal strategies have advantages in different markets. See my post on common withdrawal strategies here https://www.1engineeronfire.com/?p=73.
If you are fortunate enough to have a portfolio that far exceeds your income needs great! You are probably invested conservatively living off dividends and interest and will never run out of money. In that case a down market is of little concern.
If your portfolio is significant (>25 x annual need) but you would like to preserve your capital you may need to be flexible in down markets by adjusting your withdrawals accordingly. Small changes to your lifestyle, short term, will increase your success rate significantly.
Some financial advisors will use elaborate calculations to design a drawdown strategy that has you running out of money shortly after you die. This is a great sales tool because you set the parameters and assume all the risk. The advisor tells you that you are doing great, just keep investing with them😊. The mathematics behind these calculations are valid but do any of us really know when we will die??? If you retired based on one of these calculations you need to be very, very concerned in a down market. Consider changes to your lifestyle and check in with that advisor to recalculate your withdrawal rate so you don’t run out of money.
The chart below is an example of an advisor run simulation. Each line represents a different study of stock returns based on different possibilities. In this case all of the red lines represent return predictions where the investor is running out of money before predicted death in the year 2045.
CONCLUSION
In a down market the investor in the accumulation stage should just keep on investing. The rewards of buying low are just around the corner.
For the investors in the distribution stage now is the time to pay close attention. Stay informed of your portfolio balance and your withdrawal rate. Make changes to your lifestyle (reduce your withdrawals) if necessary to assure long term success. It’s better to leave a legacy than look for a handout!
What do you think? 1EngineerOnFIRE.com
EngFI2022
21 Sep, 2022
Posts
If you’re paying attention, you know the market goes up and down. And if you’ve been investing a few decades, you know there will be some pretty scary down periods. The good news is most bear markets are followed by some pretty aggressive bull markets.
S & P 500
2022 has been one of those bad market years. Most people have watched all of their 2021 gains disappear and it is only September! What is going on? My time in the market (~35 years) has taught me to look away in bad markets and stay the course. J.L. Collins made an analogy between stocks and beer. My interpretation was, we buy the beer (company) but it comes with some foam (market hype). The foam goes up and down but we really only care about the beer. Don’t get too worried about the foam!
I’m 2+ years in retirement and looking at roughly a 22% drop so far this year (that’s a lot of foam). I retired with a portfolio of mostly stocks (90/10) and had never owned bonds until 6 months before retirement. Then the bond market did something unusual, it dropped with stocks. Something I never observed before. Looking at my portfolio recently I noticed something interesting. My dividend stocks seemed to dip only ~12% when my other holdings fell ~25% while my “safe” bonds dropped 10%. Could it be dividend paying stocks may be a hedge to reduce losses in down markets? Perhaps this is not news to some but as a new retiree I’ve been looking more into income investing and need to learn more.
What else is going on? The Fed is trying to slow inflation with unprecedented rate hikes. And don’t forget it’s mid-term election year. The politicians in power will do everything in their power to make things look good and take credit. Those not in power will blame all things bad on the opponent. Not to worry it’s all in the foam. They are not really hurting the value of the beer!
What am I doing
Since your bonds are traditionally used to stabilize your portfolio in a down market and provide funds for buying during lows, I’ve moved 1/2 of that position back to a low-cost S&P 500 fund. My bond position will now be less than 5%. When prices recover, I’ll consider moving some of my more volatile stock to dividend stock. I currently hold ~28% conservative stock and ~28% aggressive stock with an advisor. The balance is in low-cost stock index funds with a dash of bonds.
I’m still looking for that perfect retirement mix. I still believe the advisor is worth the fee if I make the effort on my side. Besides I’m only paying the advisor fee on a portion of my portfolio and they have faired well against other investments. Once I find my perfect mix and automate my retirement withdrawals, I may go it alone.
What do I recommend?
Accumulation phase – Just keep buying VTSAX or FSROX in an IRA (Roth if you can) after getting the full match in your employer plan. If you have more to invest, do the same in a taxable brokerage account. At least 15% of your gross should be invested without fail. Pay yourself first!
If you are thinking about retirement (5 years or less) take full advantage of your employer match and keep pouring savings into a Roth, standard IRA or brokerage account. Start calculating your “retirement” number and consider adding a buffer for a market downturn in early retirement. Read Wes Moss’s book “You Can Retire Sooner Than You Think” and start preparing to be a happy retiree now!
Retired – It’s important to balance your withdrawals with your budget and use the principals of the 4% rule to fit your circumstance. As an early retiree and if your withdrawals approach 4% consider reducing your lifestyle until market conditions improve. If you did a great job planning and withdrawals are below 4% enjoy retirement as planned, you deserve it!
Conclusion
Considering this year’s events what should we be thinking? Markets go up and down and it’s mostly just the foam on top of the beer. If you are in the accumulation phase, just keep buying when stocks prices are down. If you are thinking about retiring be aware that markets can fall and having a buffer above your needs can help protect your retirement from market decline. If anything, 2022 has taught us that even bonds can be unpredictable. Strong dividend providing companies may offer some protection from market drops. Always remember it’s not timing the market but time in the market that counts.
1EngineerOnFIRE 21Sep2022
EngFI2022
2 Aug, 2022
Posts
So far 2022 has been a rough year for the markets. I can now say determining “my retirement number” and adding 40% was a good bet!
The last 2 quarters have seen market drops. My strategy has always been to look away when the market is down and stay the course. My current withdrawal rate has inched up into the 3% range. If I had retired at “my number” I would be looking at withdrawals of over 4% or making cuts to my living expenses.
The added 40% has allowed me to confidently continue our lifestyle after this latest market downturn.
If the market drops another 20% I will simply stop withdrawals for discretionary spending. Things like travel, cars, home projects and my slush fund to keep it invested while the market is down. This is my plan if my withdrawal rate approaches a 4% withdrawal rate.
One thing I noted is that the dividend stocks have held up well in the downturn compared to the other classes. I may consider this as a variation of the all in on index fund recommendation.
1EngineerOnFIRE.com
EngFI2022
15 Jun, 2022
Posts
How do you take advantage of tax-free investment growth if you don’t have an employer plan? Look to the Individual Retirement Account (IRA).
Many people have heard of or have an IRA account but the differences between Roth and standard accounts are sometimes misunderstood. I’ll try to clarify the basic differences and discuss the advantages and disadvantages of each account.
Tax Free Growth
The greatest advantage of both accounts is tax free growth. All funds placed in the accounts are allowed to grow tax free. Any growth of principle is not subject to taxation. This is a huge advantage for long-term investing as 100% of growth is added to the principle further compounding your investment dollars.
Example: $10,000 invested in a taxable account (standard brokerage account) would grow to $17,164 in 10 years (7% growth and 22% tax rate). Where in an IRA that same $10,000 would grow to $19,180. That $2,816 doesn’t seem huge but when your $10,000 becomes $1 Million that $281,000 difference gets your attention.
Standard IRA Tax Free Contributions
When you invest in a standard IRA your contribution is pre-tax. Your income in the eyes of the IRS is reduced by the amount of the contribution. This is a benefit for high earners planning to stay in a lower tax bracket. Your contribution and earnings grow tax free. The downside is you have to pay tax on the contribution and growth when you withdrawal in retirement. By age 70 (72 for younger savers) the IRS will ask you to make minimum withdrawals per a Required Minimum Distribution (RMD) schedule.
Additionally, there is a 10% penalty for withdrawals prior to age 59 ½ with a few, often misunderstood exceptions. Other than a few special circumstances you can make (SEPP) withdrawals without penalties prior to age 59 1/2. Contribution limits for 2022 apply of $6,000 ($7,000 if over 50) and are subject to employer plan availability and income rules. Non-deductible contributions are allowed for people who don’t qualify due to employer plans and high income. See the latest Tax code for details.
Roth IRA
When you invest in a Roth IRA your contribution is post-tax. Your contribution and earnings grow tax free. After 5 years your contributions are available for withdrawals penalty free but that should be reserved only for emergencies. Since you paid tax on the contributions there is no tax on withdrawals. There is a 10% penalty on withdrawals of any growth prior to age 59 ½. There is no RMD requirement since the IRS taxed your contributions.
Current 2022 tax law allows for a Roth conversion from a standard IRA but taxes are due in the year of the conversion. Contribution limits for 2022 apply of $6,000 ($7,000 if over 50) and are subject to income limits on a phased-out basis. Again, see the IRS code for up-to-date details.
What Should You Do?
Successful investors with an employer plan should first contribute at least enough to receive full employer matching funds. If the employer fund has good investment choices, like low fee index funds (S&P or similar), I recommend maxing out the employer plan. If choices are not the best due to poor fund selection or high fees then max out your Roth IRA. After meeting those criteria contribute to your traditional IRA. Any further investing can be done in a standard investment brokerage account.
I don’t recommend picking individual stocks but if you must, only do so with no more than 10% of your portfolio. See my post on picking investments https://www.1engineeronfire.com/?p=363
Conclusion
You don’t need an employer plan to take advantage of an IRA account
Tax free growth is a key advantage of both standard and Roth IRA accounts
Penalty free withdrawals on funds after 59 ½
Some withdrawal flexibility exists but you must follow the rules to avoid penalty
1EngineerOnFIRE
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EngFI2022
28 Apr, 2022
Posts
Picking The Right Investments
You have a 401-k an IRA and or a brokerage account but how do you pick from the thousands of investment choices available? It doesn’t need to be as complicated as it may seem.
There are plenty of choices: cash, money market accounts, government bonds, CD’s, short and intermediate term bonds, large-cap stocks, REIT’s, mid-cap stock, high-yield bonds, small-cap stocks, foreign stock, micro-cap stock, commodities, options, futures, limited partnerships, alternative investments, IPO’s, etc. Rest easy knowing you can reliably build wealth by focusing on US corporate stock within a single index fund.
Allocation
The first step will be to determine your allocation of investment types based on: 1) your goals, 2) risk tolerance and 3) timeline. If you need help with your allocation, check out my post on “Investment Risk” https://www.1engineeronfire.com/?p=358. Once you select an appropriate allocation you can then start looking at your investment choices.
Employer Plan
Many people do the majority of their investing via their employer’s plan. Within that plan you will have limited options but most plans cover the basics. A safe bond option, a number of stock options and typically some balanced or target date funds.
If you are a set-it and forget-it investor a balanced fund may be for you. They are often called a target retirement 2030, 2040, 2050…fund. They are a mixture of stocks and bonds based on a retirement date corresponding with the name. These funds will automatically balance the stock bond allocation based on your retirement year. I find these funds a bit conservative so dig into the details and see if the allocation mix suits your goals. Typically, these funds have a higher expense ratio (fees) because they are doing the rebalance work for you.
If you want to be more involved in your selection select from the stock options. There will often be a S&P 500 fund, Russel 2000, NASDAQ, Blue Chip, Large cap, etc. These funds attempt to mimic various stock indexes. When the names get confusing just go to the research page and do a little digging. You are looking for pure index funds or Large, Mid, Small or Micro cap funds. You could easily just pick the S&P 500 fund and get ~500 of the largest US stocks. Or make a mixture of the other funds say 30% large cap, 25% mid cap, 25% small cap and 20% international. Your goal is to diversify among the various stock classes. If your allocation is anything but 100% stock you need to mix in the appropriate amount of bonds. With this plan you will need to rebalance annually to maintain your proper stock to bond allocation.
Self-directed Accounts
If you have your own IRA (Roth or traditional) or brokerage account (taxable) your choices are virtually endless. You can invest in individual stocks, mutual funds, bonds, etc. Today’s index funds from mainstream companies are available to you at the click of a button as well as individual stocks. The data indicates consistent investing in a simple US stock index fund like Vanguard’s VTSAX or Fidelity’s FSKAX or FZROX will match market returns with the lowest fees. This is the investing strategy at the heart of the FIRE community.
If you are inclined to pick individual stocks, the data indicates you will underperform the index funds over time. But if the urge to “play the market” is strong, allocate no more than 10% of your holdings to this venture. You may catch the next rising star or buy the next Netflix the day before it drops 35%! The thing you have to ask yourself is “Are you smarter than Warren Buffett? The data suggests otherwise.
Advisor Accounts
What about advisors? Investment advisors used to be the only way the average investor could buy stocks. Now with online brokerage we can buy stocks without an advisor. A good advisor can provide valuable advice, at a cost. A bad advisor will make himself and his company rich at the expense of your portfolio. Typically, an advisor will charge 1% of your invested funds annually. That 1% gets charged whether you win or lose! Large firms, like Fidelity or Merrill Lynch, have significant research teams analyzing the markets. Their advisors have instant access to that research.
I suggest starting simply on your own with a Fidelity or Vanguard account and just buy a broad market index fund. Once your assets reach over $100,000 you may find an advisor may offer some value. They can offer other planning services and keep you on the right track in down markets. I started investing on my own and when my family and professional life became complicated, I realized I wasn’t paying enough attention to my investments. That is when I moved a portion of my investments to an advisor. At that point in my life the 1% fee was worth the advice and gave me some confidence that I was on the right track. Now in retirement, I have a proven plan in place and I may eventually reduce my portfolio share with my advisor.
Keep it Simple
As I look back on my 35 years of investing, I realize it could have been simplified. I was buying mutual funds chasing last year’s returns essentially ending up with 25 funds that made up the whole market. I did well because I unknowingly created my own index fund made up of many individual funds. The problem was, even my low-load funds had high fees compared to the modern index fund. This is why the simple index fund is so right for so many investors. These low expense (fee) index funds invest in good US companies. Companies that don’t measure up automatically fall off the index and new growing companies are added. You as the investor don’t need to perform individual company research attempting to pick the winners. You can invest that time into the things you enjoy!
Conclusion
Buy the index fund or build your own version within your employer’s plan.
Invest in a target date retirement fund if you are a hands-off investor.
Use the same strategy within your self-directed accounts knowing you have more choices.
Invest in the best low-cost index funds from proven brokerage firms.
If you must pick individual stocks, do so with no more than 10% of your assets.
Use a good advisor based on your situation but understand the cost.
Keep investing and enjoy the returns of good US companies!
1EngineerOnFIRE
EngFI2022
26 Apr, 2022
Posts
Investment Risk
On 20 April 2022 I happened to look at my stock app and I did a double take when I saw Netflix (NFLX) dropped 35%! This was a real reminder of individual stock risk. Many people think of stocks as risky investments, this Netflix drop would support their case. I would like to explain basic investment risk, how to mitigate risk and how diversification and allocation can help to reduce investment risk.
What is Investment Risk?
Per Merriam-Webster, Risk is: The chance an investment (such as a stock or commodity) will lose value. Warren Buffet’s #1 rule of investing is “Never Lose Money”.
Investments Types by Risk
Low risk investments – Cash, Money market accounts, Government bonds, CD’s, Short and intermediate term bonds.
Medium risk investments include – Large-cap stocks, REIT’s, Mid-cap stock, High-yield bonds and Small-cap stocks.
High risk instruments include – Foreign stock, Micro cap stock, Commodities, Options, Futures, Limited Partnerships, Alternative Investments, IPO’s, etc.
Low risk investments historically do not keep up with inflation so we must look elsewhere to grow wealth. Many investors do not have the risk tolerance or knowledge for success in the high-risk category. For these reasons the smart investor will focus on the mid-risk category of US corporate stock.
According to NerdWallet the average annual stock market return is 10% https://www.nerdwallet.com/article/investing/average-stock-market-return. This is in line with the S&P 500 historic returns but a bit above the Dow Jones historic average return. Along with the compounding effect a 10% average return can help any investor grow wealth.
Company stock risk comes in two basic forms:
Systematic risk – Market risk or things that generally affect the market as a whole. Things like inflation, recession, interest rate changes, political factors, etc.
Unsystematic risk – Risk unique to an individual company. Examples would be Elon Musk making a bold statement to the news media affecting Tesla’s price or Netflix servers crashing causing loss of subscribers, Kodak not getting into digital cameras etc.
With this basic understanding of both basic stock investment risks, you can see the average investor has no control of either. So how do we reduce this stock risk?
Mitigating Investment Risk
If you invest 100% in Tesla stock and Elon Musk announced he believes in aliens and the tooth fairy the stock could fall to zero. You then lose 100% of your investment. But if you owned 50% Tesla and 50% IBM your total loss would be reduced to 50% because IBM didn’t fall. To reduce that even further spread your investing over more stocks.
So why not buy 500, 1000 or 3000 stocks and reduce your risk even further? When you buy an index-style mutual-fund you are doing just that. Now if Elon makes a crazy claim his share of your total becomes almost insignificant. You still share in the systematic risk of the market but unsystematic risk is minimized.
What do you give up when buying “the market” in large index-funds? You give up the highest returns if you had only owned the top performing stocks. You still benefit from their return but you have to average those returns with the lesser performing holdings.
So why not just buy the top performers? The data indicates even the best investors can not pick the top performers year after year. You can’t pick them either!
Diversification and Allocation
Diversification – spreading risk over a number of assets within a given asset class.
Allocation – Balancing the different types of assets classes based on goals, time and risk tolerance.
I’ve already discussed that owning an index fund buys hundreds or thousands of stocks. An S&P 500 fund like Fidelity’s FXAIX automatically diversifies (~500 stocks) your stock holdings within the large-cap asset class. If you were to own Vanguard’s VTSAX fund you would own over 4,000 stocks and cover large, mid and small cap asset classes.
If you have over 5 years to grow your wealth and a good risk tolerance, I think a 100% stock allocation might be just fine. But if you are near or in retirement or don’t like to see big value swings you should look into a different allocation.
The trick with any allocation is you need to stick with it. You can’t claim to be an aggressive 100% stock investor and then sell out when the market drops 30%. This will guarantee failure! You also need to understand $50,000 will only grow to about $103,000 in 10 years in a conservative 40/60 stock/bond portfolio. I like this chart I found at optimizedportfolio.com. At a glance you can see the average expected rate of return with various allocations.
Ref: optimizedportfolio.com
The bars represent the best and worst one year returns for each allocation from 1926 thru 2019. One way to set your allocation is to look at the worst return (number at the bottom of the bar) and ask yourself if you can tolerate that amount of annual loss. For example, if you think a 25% loss in a single year would have you selling then you better not have more than a 50% stock allocation. If you have 2 decades before you need your money and you can ride out a 40% loss then you might be able to tolerate 90% stocks and can then expect 10% returns.
Of course, there are many variables and this is all based on past performance. Bonds are currently underperforming historical data so maybe add 10-20% more stocks to be a bit more aggressive. If you think you will exceed your portfolio needs, have a pension to fall back on or plan to supplement income with work I’d go more aggressive as well. If you are conservative and will have more than enough to meet your needs, stay safe and allocate 40% to 50% bonds. I would not recommend more than 75% bonds for the most conservative investor. It’s just too hard to keep up with inflation when returns fall below 7%.
What does 1EngineerOnFIRE do?
Throughout my working years my allocation was 100% stocks. I new I had strong investing discipline and would not sell in a down market. I dollar cost averaged monthly in my 401-k and bought IRA’s every year until I was well ahead of my goals. In the months leading up to leaving the workforce I did move ~10% of stock to bonds.
Now 2 years into retirement I’m slowly rebalancing to an 80/20 stock/bond allocation. I make quarterly withdrawals from my portfolio (3.1% annual rate). That 80/20 allocation should result in a 9.6% average return. Well above my 7% long term goal!
