How We Invest: In Capital Markets We Trust
By popular demand (by which I mean a single request), here is more detail on step two of the early retirement plan, investing surplus income.
How We Learned to Stop Worrying and Love The Market
At one point, our savings were sitting in savings accounts being idle instead of working for us. There was a few things that held us back:
- We didn’t have that much extra income to save back then
- We didn’t know what we were saving for
- We had to decide how to invest
- It was easier to do nothing
We were able to overcome the hurdles and inertia with research, discussion, and help from Bogleheads. In developing an investment strategy, there are two things that turned out to be important:
We can be risk averse, and our decisions might be too conservative for some; our strategy suits our comfort levels and has worked for us: we’re happy to throw extra money into our investments month after month without any worry about the current state of the market.
The majority of our investments are represented by three low cost index funds. These funds allow us to
- Own the entire U.S. equity market,
- Have equity exposure to both developed and emerging international economies,
- Get broad exposure to U.S. investment grade bonds.
The Tell-Tale Chart
If we ever need to steel our nerves regarding market fluctuations or remind ourselves of the power of diversification, we take a look at a total return chart of the three constituents of this simple portfolio over a suitably long time period:
The chart above includes the so called “Lost Decade” and the 2008 stock market crash that ushered in the “Great Recession” and that chart still looks great to me. Returns were good, and each of the asset classes did their jobs: Bonds rose slow and steady while equities were a wild ride and paid off for those who held on and didn’t sell in a panic; sometimes US markets outperformed international stocks, sometimes the opposite was true, we don’t have a crystal ball so we own both in equal proportions (conveniently, this closely approximates market capitalization weighting, while being nice round numbers).
There are a ton of articles on selecting an asset allocation. You can read as many of them as you want and will probably be left with a lot of different opinions, that’s life and most people’s crystal ball is unpredictable.
The book Your Money or Your Life (the original financial independence book?) recommends holding only government bonds and living off the interest (frankly this is pretty bad advice, unless you are extremely risk adverse and/or incredibly patient). On the other extreme are those who are happy to hold all stocks and hope to enjoy the reward of higher expected returns.
A 25% fixed income allocation might seem conservative to some, especially as we are aspiring early retirees. In the past, our investments were even more conservative, at 60% equities and 40% fixed income. The stocks let us eat well, the bonds let us sleep well.
Everybody has a plan until they are punched in the face
I started investing at 25, and after some thought decided on a 60/40 allocation as right for me. I had worries that I was being too conservative and was going to miss out on returns but went ahead with 60/40 as that is what I felt comfortable with. This was 2007, and shortly thereafter, the financial crisis hit.
My meager savings took a hit, but due to the balanced portfolio, the losses weren’t terrible and I found I was perfectly happy to keep contributing money regularly, even amidst all the talk of gloom and doom. I bought up equities to get my asset allocation back in line with where it should be and that has paid off over the last few years. I think having an asset allocation that I was comfortable with helped me in being able to stick to my plan instead of panicking.
Getting married and combining our finances, we had to decide on an asset allocation that worked for us both. The DJ had been all cash savings until this point so continuing with a 60/40 equity/fixed income allocation seemed aggressive enough for our comfort levels at the time.
We were able to stick to that allocation, even when for example we came back from vacation in May 2012 to find we’d lost the equivalent of a month’s pay in the time we were gone. We had no problem making our next regularly scheduled contribution. If we had found that we lost two months salary, I like to think we would have felt just as comfortable, but who knows…
In our view, having a plan that works for you and that you think you can stick with is a lot more important than having an “appropriately aggressive” asset allocation for your age.
Of course, we did compensate for our conservative asset allocation with a very high savings rate. A high savings rate washes away many sins.
Changing Asset Allocation and Accounting for Home Equity
A subsequent home purchase coinciding with increased tolerance for stock market risk served as a good time to revisit our asset allocation and verify that it still met our goals. We were also wondering whether our asset allocation should account for home equity, there were multiple opinions.
A personal residence has characteristics that make it a poor investment (hard to value, non-liquid, non-diversified, high transaction & carrying costs), but it’s also true that our financial well being is now as much tied to the local real estate market as it is to equity and bond markets. The imputed rent we receive by being homeowners has a bond like characteristic: regular guaranteed payments over time, though that payment is implicit rather than explicit.
We subsumed home equity into our fixed income allocation (aiming for no more than half, or 20% of our net worth). The end effect is that our now smaller pool of investable assets are allocated more aggressively: 75% equities and 25% bonds, while our overall asset allocation remains at the original 60 / 40, assuming that home equity can be counted as part of the fixed income portion.
Even more complicated: Slicing, and Dicing, and Tilting! Oh My!
Coming clean here: our investment holdings are a bit more complicated then I alluded to with the three fund portfolio. Part of the reason is simply fund availability in our employer sponsored 401k accounts and having to approximate the total stock market with multiple funds.
However, the main reasons for the extra complexity are, mea culpa, tinkering, over-optimizing, and curiosity about new investment options. The three fund portfolio, or approximations to its constituents still make up the bulk of our portfolio, with most other holdings making up less than 5% each..
In building up our equity allocation we slice and dice and
- overweight REITs, to exploit varying correlation with other asset classes.
- value tilt, and tilt to size (small). Aside from the academic research, and the past over performance, I’m a bit uncomfortable that large growth stocks make up such a large part of a market capitalization weighted portfolio and view value and size tilting as a way of countering that.
On the fixed income side, we
- hold TIPS in addition to nominal bonds, there are arguments for and against this, we value the added protection against unexpected inflation.
- have a small high-yield bond allocation to better align with the actual total bond market. This is not a holding if you want only safety and stability from your fixed income allocation, there is however an interesting argument that this asset class might represent a small market inefficiency as some institutional investors are not allowed by policy to hold lower quality bonds.
- haphazardly hold international bonds. I’m open to the argument that international bonds belong in a portfolio for diversification, but not sure if it over comes the extra cost and currency risk.
- participate in peer-to-peer lending through Lending Club, partially out of curiosity.
Certain decisions, over-weighting REITs and holding high yield bonds for example, may have been influenced by earlier thinking that for some reason had a particular affinity for income paying investments as opposed to total return (at least there are no dividend growth fund on that list…). At least over the last few years, people stretching for yield (not a good idea) have driven up these positions. We’ll take being lucky over being good.
Our range of investments may be more complicated than needs to be and the majority of the return is probably a function of our relative exposure to bonds and equities, not the individual holdings. The simplicity of the three fund portfolio is alluring, and we will probably re-evaluate all our decisions at some point, but for now we are happy to stick to the plan adding funds and re-balancing as necessary.
There you have it, more then you wanted to know about our investment strategy and rationale. Feedback always welcome.