How you allocate your investments will play the most important role in your return on investment over time.

This simply means that how you allocate your investments between stocks, bonds, real estate, and cash is critically important to your return on investment over time. Asset allocation is much more important than when you buy, what you buy, or where you buy.

Big returns come with big risk, there is no way to avoid it

If you want decent returns you must assume more short-term risk with your money. That means owning stocks and then do it inexpensively  by owning no-load stock index mutual funds. You can see the ups and downs in the markets and the historical returns (before costs) on each type of asset allocation over the last 100 years in the below table.

Ask yourself these questions

What is my time horizon? What are my goals? What is my risk tolerance? What income if any do I currently need? Finally, what is my tax situation? Answer these questions and you are well on your way toward identifying the right asset allocation for you. Keep in mind. This is not a perfect science. What is right for someone else may not be right for you. Focus on understanding your situation.

Once you identify your desired asset allocation, arrange your investments to reflect that

If a 60% stock and 40% bond and cash allocation is right for you, you would take your total amount invested and divvy it up in those proportions. For example: If you had $100,000, you would place $60,000 in stocks and $40,000 in bonds and cash. Set it up using your company retirement plan, a Roth IRA, and taxable accounts (non-retirement accounts) and then leave the portfolio alone until you need to rebalance (sell some of your winning investments and buy some of your losers to get back to your 60% stock / 40% bond desired allocation.

See the below tables for example portfolios.

Focus your efforts on owning broadly diversified no-load index funds that provide you exposure to entire markets and continents at a very low cost

This would lead you to a total stock market index fund, a total international market index fund, and a total bond market index fund or a short-term bond index fund. Add other index funds like a REIT Index Fund, a Small-Cap Value Index Fund, and an Emerging Markets Index Fund as the portfolio grows over time. Your portfolio costs should be under .30% and ideally closer to .10% as the portfolio grows bigger over time and you acquire admiral shares at Vanguard.

Rebalancing is needed to keep your asset allocation where you want it

Over time your portfolio can end up out of whack because the stock or bond markets have done very well or very poorly. You will need to rebalance when that occurs.. Do this in retirement accounts (to avoid a taxable event) or simply reallocate your monthly contributions to the securities that you want to build up (invest in bonds instead of stocks for example if you need to build up on your bond allocation).

This sounds reasonable, but it can be difficult. You will need to sell your winners and buy your losers. That can be hard and counter intuitive. An easy way to approach this could be using Target Retirement Funds that automatically rebalance for you.

Understand modern portfolio theory when allocating your investments and monitoring them over long stretches of time

This means looking at your entire portfolio, rather than individual investments within it. In any given year, some investments will do better than others. This will happen. We just don’t know which ones will trump the others in any given time period. This is why we own multiple asset classes as we diversify over many parts of the world.

Do not chase performance. This simply means you don’t sell your losers and buy your winners (that is actually the opposite of what you should be doing, which takes you back to the rebalancing approach). This is part of becoming the wise and efficient investor.

Use modern portfolio theory to allocate your investments in different accounts

The actual application of this concept does not have to be difficult. Look at your company retirement plan like a 403(b), 457, 401(k), or TSP, a Roth IRA, and any taxable accounts you may own as you divvy up your money. Most people should strive to keep most of their money in retirement accounts as they shelter their yearly income from taxes. Place tax efficient assets outside of retirement accounts when investing. The Total Stock Market Index Fund and Total International Stock Index Fund at Vanguard would be two examples of tax efficient investments.

Take the time to educate yourself on recency bias and reversion to the mean

Recency bias affects us all in different degrees. Allowing recent events to cause us to buy or sell our investments is a big mistake. We must fight that urge and always think long term and that means understanding historical returns, not the last month or even the last week! Reversion to the mean reminds us that markets do not go up or down forever, even when it may feel like it (markets can go in one direction for weeks or months at a time based on nothing but speculation). Again, we want to look at historical data when considering our investments and what they might return. Ignore big gains or drops. Reversion to the mean will follow at some point, it always does.

Know thyself.

John Bogle ( a very wise man) recommends you keep your bond and cash allocation at a number that equals something close to your age. If you are 60 for example, then you would have 60% in bonds and cash, and 40% in stocks. This is quite conservative, but he would tell you that people are not as aggressive as they say they are. It’s one thing to talk about the markets dropping, it’s something totally different to experience it first hand.

Add to your U.S. and International broad market stock index funds with smaller markets that add diversification (REIT index fund) and overweighting to small and value companies (applying the research from Fama and French)

It is prudent to add more diversification to your portfolio whenever possible while considering costs all along the way (international markets outside the U.S. are more expensive and that should be weighed carefully before adding more international investments). Learn more about Fama and French’s three factor model here: http://www.investopedia.com/terms/f/famaandfrenchthreefactormodel.asp

Focus on quality (no junk bonds) and term (stay with short and intermediate maturities) when owning bonds in the U.S. and International broad market bond index mutual funds.

This is all about taking risk with your portfolio in a smart way. Do not take unneeded risk with your bonds (avoid high yield junk bonds, long term bonds, and individual bonds). Own quality and short to intermediate-term bonds only. If you want to take more risk in your portfolio, own more stocks. Don’t do it with bonds.

Always focus on no-load index mutual funds with ultra low expenses when you put together your portfolio

Index funds outperform managed mutual funds consistently over time. Why? Cost is the primary reason. This is all about playing the probabilities over the possibilities. Focus on investing at the lowest possible cost and over time your investment account will show you a much bigger return. It is always wise to listen to Burton Malkiel, author of A Random Walk Down Wall Street: https://www.youtube.com/watch?v=qgYF9q9gyis.

Not all index funds are the same

Focus on finding mutual funds within your retirement plan at work that mimic benchmark indexes like the Russell 3000, Wilshire, 5000, or S&P 500 when focusing on your core stock holdings. Next, focus on costs. The cheapest index fund will always outperform an identical index fund that is invested in the same securities. Identify the lowest expense ratio when investing your money. The expense ratio should be below .3% and ideally below .1%. Vanguard tends to do this better than anyone else. Consider them when investing outside of your company retirement plan (or inside if Vanguard index funds are offered).

Anyone can tell you who won last year’s Super Bowl, but no one knows who is going to win this year’s Super Bowl

You do not need to be a rocket scientist to find managers who have beaten an index (it happens every year). That is the past and it tells us nothing about the future. Telling you about the 30% who performed well (and then in many cases making a comparison to an index that does not reflect the stocks that are owned) and disregarding the 70% who did not is dishonest if not immoral. Don’t fall for it. Picking the future winners is a fool’s errand. Don’t play a game that is stacked against you. Play the odds and buy index funds!

Consider a Target Date Retirement Fund that owns index funds

Vanguard provides many target date funds that own nothing but Vanguard stock and bond index funds that diversify you all over the world. These funds are super cheap (.16% to .18%) and they rebalance on their own over time (buy or sell stocks to get you back to your desired asset allocation) so you don’t have to. For many people, these funds could be ideal options. Learn more here: https://investor.vanguard.com/mutual-funds/target-retirement/#/

Not all target date funds are the same

Focus on costs when considering whether to invest in target date retirement funds at your retirement plan at work. This means identifying target date funds that own index funds rather than managed funds. Do not own Target Retirement Funds that have costs above .3%. This approach will eliminate managed funds and keep in mind, many target retirement date funds use managed funds. Becoming the wise and efficient investor will allow you to pick and choose the right investments as you avoid the wrong investments.

“Invest in low-turnover, passively managed index funds and stay away from profit-driven investment management organizations. The mutual fund industry is a colossal failure resulting from its systematic exploitation of individual investors as funds extract enormous sums from investors in exchange for providing a shocking disservice. Excessive management fees take their toll, and manager profits dominate fiduciary responsibility.” – David Swensen, The Highly Successful Chief Investment Officer of Yale University

“Fund investors are confident that they can easily select superior fund managers. They are wrong. Index Funds eliminate the risks of individual stocks, market sectors, and manager selection. Only stock market risk remains. Don’t look for the needle, buy the haystack.” – John Bogle, Institutional Investor’s Lifetime Achievement Award (2004)

“Most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professions.” – Warren Buffett, The Greatest Investor of the 20th Century

Examples of stock index funds

Examples of bond index funds

Examples of Target Date Retirement funds

Returns of the above funds

Finley’s Desired Portfolio

$10,000 Portfolio Example

$50,000 Portfolio Example

$100,000 Portfolio Example

When investing in your company retirement plan (defined contribution plan), steer clear of managed funds whenever possible (when no index funds are offered, go with the managed funds with the lowest expense ratio)

Always play the probabilities over the possibilities (it is probable that the index fund will beat the average managed fund that owns similar investments). Education on the matter will help in understanding the forces working against you and how you can overcome them. Here is a documentary that explains the issue quite well: http://www.pbs.org/wgbh/pages/frontline/retirement-gamble/.

Seek out broad market (large markets that own thousands of securities) index funds whenever possible based on your particular retirement plan at work

Each retirement plan will be different based on the provider and the contract that has been agreed upon with the employer. You know you have a good plan when you see many inexpensive index funds offered and you know you have a bad plan when they are not there. Average fees (expense ratio) above 1% identify a bad plan. If you are paying loads (commissions) within your retirement, you are getting robbed! You should never pay loads within a retirement plan.

Your company retirement plan (401k, 403b, TSP, or 457) will offer many different types of funds that may or may not be worth investing in

Here are the basics on what you do want. A total stock and/or bond index fund that owns an entire market is a good place to start. Look for key words like total (not always in the name) and index when making your selection. If it does not say index, don’t bother with it (the one exception to this rule would be target date retirement funds and lifecycle funds that own index funds, but will not say it in their name, also, all TSP funds are index funds even though they do not say it). Review the fund facts on each fund that fits your criteria to better understand what they are investing in.

Many people will have 3 buckets and then a 4th over time

These buckets (places where you hold your investments) would consist of (1) an emergency account, (2) a retirement fund account at work, and (3) a Roth IRA account outside of work. The 4th bucket that is created over time should be a traditional IRA (and/or a Roth IRA) when moving Traditional or Roth money from old retirement plans. Do not let old retirement plans sit out there in the ether doing nothing! You want to make sure the investments within each bucket work in tandem with the investments in the other buckets (think back to negative correlated assets and categories). This goes back to our section on asset allocation.

There could be a 5th bucket which would be taxable index funds outside of retirement plans (this would be in addition to the bond index fund where you hold your emergency account)

This would be a place where you invest when you have maxed out your retirement accounts for the year ($18,000/$24,000 for retirement plans at work and $5,500/$6,500 for IRA’s outside of work for people under 50 and 50 and older in 2015). This is also a bucket you would use if receiving large chunks of money from an inheritance, life insurance proceeds, etc. You want to make this type of fund very tax efficient to reduce your capital gains taxes for the year. The Total Stock Market Index Fund and Total International Stock Index Fund at Vanguard would be wise choices

You can have multiple funds in your buckets or just one (consider how much money you have, options available in your bucket, and need for further diversification)

For example, your Roth IRA might consist of $10,000 in a REIT Index Fund and $10,000 in a Small-Cap Value Index Fund after you split up the REIT Index Fund when it reached $20,000. You can do this within your retirement plan at work as well. Neither of the moves would cause any taxable event that would force you to pay tax on the transfer. It would if you did this outside of retirement in your taxable bucket so that should be avoided in almost all cases.

Be sure to feed (or withdraw from) each bucket within your portfolio in accordance with your desired asset allocation

This simply means that you will want to keep an eye on your asset allocation when you are making contributions or withdrawing money in retirement. Taking the time to make the proper selections is very important. Feeding those selected funds consistently over time is also very important (it is critical to save at least 10% of your gross income and preferably 20% if you want to see big results over time). Monitoring how much you have of each asset class and category as you contribute or withdraw follows along after those two areas of emphasis.

For many people, owning a Target Date Retirement Fund or Lifecycle Fund within their retirement plan at work and then individual index funds in their Roth IRA(s) will work quite well

This approach will allow for normal rebalancing within the Target DateFund/Lifecycle Fund (they will own broadly based funds as recommended in most cases) with no effort on your part and then the Roth IRA’s provide you that extra diversification (REITs for example) and/or overweighting (Small-Cap Value using the Fama and French research for example). This will also provide you a way to glide into retirement as your balanced fund becomes more conservative (more bonds). Just make sure those Target Date Funds/Lifecycle Funds own index funds!