There are things in life that are hard, really hard, like visiting your family on Thanksgiving and hearing the same 5 stories that they have been telling about you for the last 10 years, like saying goodbye to Grandma when you’re moving across the country, or like smiling and nodding when your significant other is just being unreasonable. But there are also easy things in life. For example, ordering a shake at your favorite fast food place, or binge watching your favorite show for the millionth time on Netflix. And then there are simple things like checking to make sure that investment you are making is balanced in terms of the long run.
I am a millennial but I have been lucky to manage my own investments for more than a decade at this point. Having been privileged to do so I have now gone through all the normal stages:
- OMG I am going to make so much money investing. Check out how stock X did while I owned it. I have now earned an entire $5 dollars.
- Ok investing in stocks is hard and it seems random, maybe I’ll pick some mutual funds. How did these few do in the last couple years?
- Checking past performance is getting old, it takes too much time and it seems to be subjective. How do I make this a bit more rational.
Luckily, I stumbled onto the theories of Harry Max Markowitz, a nobel prize winner, and some more practically minded people that implemented Markowitz’s approach – Jack Bogle of Vanguard and his loyal followers on bogleheads.org. Feel free to explore, and I will see you back here in 3 weeks.
For those of you still with me, the key takeaway of Markowitz’s theory is that investment risk is minimized by diversifying the investments you own. To really understand this statement we need two definitions:
- investment risk – The risk that when you want to withdraw your money, the investment you own will be worth less (often temporarily) than the amount of money you used to purchase the investment.
- diverse investments – Investments that tend to move in opposite directions given the daily events. The classic example here is stocks and bonds which should move in opposite directions during boom times and recessions.
So putting this together, a good portfolio of investments is one that reduces risk through diversity. The ultimate diversity strategy is to buy one of everything (stocks, bonds, houses, etc. etc.). In simple terms this is what an index fund is. For example, the Vanguard Total Market Index Fund is simply a collection of all Stocks on the US stock market. Similarly, the Vanguard Total Bond Market Index Fund is a collection of bonds representing the total US bond market.
So a good diverse set of investments is simply a large number of different investments (ex. stocks and bonds) that one “hopes” will move differently during recessions and boom times. A convenient example here is a Target Date Fund. Notice, how its made up of different types of investments?
In case you are wondering, the percentages in these target date fund are simply the professional’s best guess at what someone your age can handle. What do I mean by this? Well, the professional are guessing that with a given balance of bonds and stocks (again age dependent) you wont run for the hills in the next recession and sell your investment. As you get older, you tend to freak out more about your nest egg, so they add some bonds to hopefully make it smoother. The moral of the story is, think carefully about how you react then choose your balance.
Finally, once you have selected your diverse set of investments, ask yourself, how much am I paying annually for these investments? If the answer is more than say 0.5% then you are probably paying too much. Again, I point you to the wonderful work those folks are doing at Vanguard that shows you the expensive guys just ain’t worth it.
That’s all folks! If you want to know if your investment is good ask yourself:
- Is the set of investments I’m holding diverse enough?
- How much am I paying annually to hold these investments?