The Simple, Effective Approach to Investing (Part 4): Implementing Your Investment Plan

This is part of a four-part series on investing basics. You can follow along with the entire series here:
-Part 1: Where do investment returns come from?
-Part 2: Investment risk and return
-Part 3: Determine your asset allocation
-Part 4: Implementing your investment plan

In the past three weeks, we’ve gone over some of the basic principles of investing. We’ve talked about the factors that drive investment returns, the relationship between investment risk and return, and some of the things to consider when deciding upon an asset allocation strategy.

At this point, I’ll assume you’ve gone through all three topics and have an understanding of the important factors to consider when developing an investment plan, as well as an idea of the asset allocation strategy you would like to use. Today I will talk about some of the factors to consider when actually choosing your investments and implementing your plan.

The default path

The default option for every new investor should be a single, low-cost fund that approximates the asset allocation you desire. A good example of this approach are the target date retirement funds offered by many investment companies. These funds have a “target date” that is meant to represent the investor’s year of retirement. They typically invest in other funds representing stocks, bonds and potentially other types of holdings as well. In general they start out with a more aggressive asset allocation (more stocks) and slowly become more conservative as that target date approaches. If you’re looking at target date funds, keep in mind that you don’t have to choose the one that lines up with your expected date of retirement. You can examine each fund and choose the one that is most aligned with your asset allocation preferences.

Although target date funds are the most talked about, other single-fund options exist. A balanced mutual fund is simply one that invests in both stocks and bonds. These funds may keep a relatively stable asset allocation, or they may change over time either according to a pre-determined timeline or based on the manager’s discretion.

A solid all-in-one fund is great for simplicity’s sake. You don’t have to manage and keep track of multiple funds, you don’t have to worry about rebalancing, and you have a single destination for all of your contributions. I believe this should be the default option for new investors because it removes much of the potential complexity and burden from investing and delivers most of the benefits.

Remember, the most important thing is that you choose a good enough strategy and get started with it. If getting bogged down in the details is going to delay action, choose a simple way to get started now and worry about the details later.

What factors matter?

Whether you go with a single fund or you want to build your investment portfolio piece by piece, there are several important factors to keep in mind as you make your choices.

Market representation – The very first factor you need to consider is whether each particular investment adequately represents the portion of the market you want to invest in. It sounds simple, but suppose you’ve decided that a certain portion of your investments should be in US stocks. The most common type of US stock index fund is an S&P 500 fund, which represents the largest US stocks. But your goals might be better met by a fund that actually represents the entire US market: large, small and in between. As another example, you don’t want to choose a fund that invests in corporate bonds if your goal is to invest in US Treasury bonds. Make sure you read over the fund’s description to get a true understanding of what slice of the market it’s representing and whether that aligns with your goals. Morningstar is a great resource for this.

Costs – Understand that costs matter. A lot. Morningstar actually published a study showing that costs were the single best predictor of mutual fund returns, even better than their star rating system. Every dollar you pay in fees equates to many dollars of lost returns when you factor in compounding over many years. Don’t let high costs drag you down. As the great John Bogle once said: “In investing, you get what you don’t pay for.” You can read this for a more complete overview of what kinds of fees you should be trying to minimize.

Tax characteristics – If you’re investing in a 401(k), IRA or other tax-advantaged account, then taxes are a moot point. But if you’re investing in a regular taxable account, then taxes matter a great deal, as they drag down returns just as other costs do. The same post on costs that I linked to above has some further description on how to estimate a fund’s tax cost. The less you have to pay in taxes, the more money will be left for you. In general, actively managed funds tend to have a higher tax cost than index funds.

Length of fund history – The length of time a particular fund and its manager have been around matters. A fund with a long track-record gives you more certainty that it will continue to do what you expect. A new fund might come with a lot of hype, but you don’t really know how it will behave through the market ups and downs. The same is true of a new manager, even if the fund has been around for a while. Change is not always bad, but it creates uncertainty. A long history of consistent behavior is what you want to look for.

What types of investments?

A lot of people like to start with the debate of whether you should be buying mutual funds or picking your own stocks and bonds. While that decision matters, it should only be made after considering all of the factors above.

It’s my belief that almost all investors should stick with index mutual funds or ETFs. Not only have they proven to beat stock-picking strategies year after year, but it’s a much simpler and more consistent approach. When you pick an index fund, you can be very sure about how it fits into your asset allocation, and you can be confident that it will continue to meet that same criteria over the years to come. When you use active funds or pick individual stocks and bonds, the asset allocation fit becomes much blurrier and will shift over time, causing even more work beyond the initial selection.

Don’t get hung up on the difference between mutual funds and ETFs. They are very similar in how they work, so either one will do as long as they meet the other criteria. If you’re choosing between one or the other and all other factors are equal, I would go with the mutual fund for simplicity’s sake.

Summary

The main points to keep in mind as you make your selections are these:
1. Stick to your asset allocation plan
2. Keep costs low
3. Keep it simple
4. Just get started

Points 3 and 4 are crucial. Simplicity will not only help you stay on top of what you’re doing, but it will often result in better returns. And no matter what, just get started. You can do all the research in the world, but experience is often the best teacher. Stick with your plan, re-evaluate on a regular basis, remember that there will be ups and downs and that consistency is the key to success, and learn as you go.

“When there are multiple solutions to a problem, choose the simplest one.”
-John Bogle

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  • Holly@ClubThrifty May 29, 2013

    I like target date funds because I don’t want to have to tinker with things too much. It’s not that I don’t think I’m smart enough to invest myself. I just tend to make emotional decisions and leaving money in target funds means the right decisions are (hopefully) made for me.

    • Matt @ momanddadmoney May 29, 2013

      I think it’s a great call to be aware enough to take the emotions out of the process. Even with a target date fund, you want to be checking in to make sure it still aligns with your goals, but you’re absolutely right that a good one will put good decision-making on auto-pilot.

      • Andrew May 30, 2013

        Good point! A lot of people pick a target date fund which correlates to when they plan on retiring, but you should check to see if the allocation aligns with your goals. I think that after the 2008 stock market crash, some people realized that their target fund was more risky that they wanted it to be.

        • Matt @ momanddadmoney May 30, 2013

          Agreed. They typically assume that a young person has a higher risk tolerance, which just isn’t always the case. I understand the reasoning for more stocks when you’re younger, but it’s just not true that all young people will be fine with huge ups and downs.

  • John S @ Frugal Rules May 29, 2013

    Good post Matt! I think a big key here is the expenses. People hear index fund or TD fund and they think they’re all equal when in reality they’re not, which is why doing your due diligence is vital. I do think many investors are best served by looking at index funds, especially if they lack the time/knowledge. I personally think solid dividend payers can be a good option as well as long as you know how they fit in your portfolio and avoid a set it and forget it approach that goes on into perpetuity.

    • Matt @ momanddadmoney May 30, 2013

      Great point about all index/target date funds not being equal. Just as with anything else, there are good ones and bad ones. It’s discouraging to see people hopping on the bandwagon of a particular label just to help sales, but it’s part of the business.

      As for dividend investing, I’m hopefully going to have a post on that soon. While I understand the logic and think it can be a decent strategy for some, I think it’s usefulness is being overplayed these days.

      • John S @ Frugal Rules May 30, 2013

        I completely agree Matt. I think they can be good as long as you do your due diligence…not to mention the fact of not jumping on the dividend stock bandwagon many seem to be getting on these days. I think they have their role, but should not be done blindly.

  • DJ Wetzel May 30, 2013

    Automating my investments into a low-cost index fund was the best decision I ever made!

  • cashRebel May 31, 2013

    Do you have an opinion on whether the S&P 500 index is “international” enough? Or would you also include a purely international index fund?

    • Matt @ momanddadmoney May 31, 2013

      I personally use only 2 index funds for the stock portion of my portfolio: Vanguard’s total US stock market fund (VTSAX) and their total international fund (VTIAX). I like being diversified across all of the world markets and I also like including the smaller US companies that aren’t part of the S&P 500. While the companies in the S&P 500 obviously do a lot of international business, they aren’t representative of those international economies. With that said, I don’t think you’re making any huge mistake by only using the S&P 500. I just think there are some simple ways to do a little better.

  • 2-copper-coins.com November 20, 2013

    We are major believers in index mutual funds. I appreciate the discussion about whether your investments are actually going to the part of the market (or the best representation of the market) you think they are. Excellent post!

    • Matt @ momanddadmoney November 21, 2013

      Especially with active funds it can be pretty tricky knowing whether you’re getting the asset class you actually want. Index funds make it a lot easier.

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