The following rules form a sound, effective, and easy-to-use investing method. Stick to them, and they’ll lead you to a successful semi-retirement.
Own Diverse Asset Classes
Successful investing starts with creating a portfolio with the right assets. This means combining stocks, bonds, and other non-correlated assets that’ll give you the same – or better – returns than individual securities from just a few asset classes.
This works because small amounts of volatile – yet high-return – assets will increase your overall portfolio performance with little additional risk.
When one asset increases while another decreases, your overall portfolio stays steady.
Here’s a secret: All the big successful institutions invest this way to ensure a safe provision of steady income.
They don’t spend time picking stocks and bonds. They just pick asset classes that have worked well together in the past, and find managers who deliver that asset class’s performance consistently and at a low cost.
For most investors, a rational portfolio will consist of 40% stocks, 40% bonds, and 20% other – including commodities, market neutral hedge funds, and real estate. Since these assets are less correlated with the main stock and bond asset classes, they’ll provide real benefits to your overall results.
There are three benefits to following this allocation method:
- It can be used by both younger and older investors.
- It supports steady withdrawals through all kinds of markets.
- It has a good chance of keeping up with inflation.
Demand Low Fees
Your portfolio’s fees should average below 0.5% a year. And by choosing certain funds, you can lower your fees even more – down to the range of 0.2% per year. Fees higher than this just eat up too much of your expected return each year.
To determine your fees, check out your fund’s prospectus. Or go to Morningstar and enter the ticker symbol.
In the past, fund management companies only offered these low prices to large institutional investors. Luckily, they’re now available to average investors too.
For instance, you can get international small stocks, emerging market stocks, international bonds, and other previously hard-to-get assets at fees in the 0.2% to 0.5% per year range.
A portfolio has a tilt when it holds more of an asset class than normal. For instance, the Total U.S. Stock Market Index contains under 7% small stocks. So a portfolio with more than 7% small stocks is tilted toward small stocks.
International stocks and bonds, as well as small stocks, are good asset classes to tilt towards. Their low correlation with other assets mean they can lower your overall portfolio risk while providing good returns.
Keep Volatility Low
Volatility refers to the up and down swings in the value of your portfolio.
For instance, the S & P 500 is pretty volatile. Although its average return from 1988 and 2006 was 11.8 percent per year, actual annual returns fluctuated widely.
Some years had big gains, while others had big losses. This distribution is measured by what’s known as standard deviation. For the S & P 500, this number is 14.75 percent.
What this means is that, in any given year, the S & P 500 to fall – with 68 percent certainty – within one standard deviation above or below the average return. In other words, between -0.3 percent and 26.5 percent.
If you move two standard deviations away from the average – between -17.7 percent and 41.3 percent – your returns will fall in this range 95 percent of the time.
So what’s the point?
If you’re looking to retire early, don’t try to achieve the highest return at the expense of high volatility. Instead, choose a mix of assets to provide an acceptable return at the lowest risk. This usually means lower amounts of stocks than other long-term investing models promote.
Steven Evanson of Evanson Asset Management offers a useful guideline as it relates to risk and reward: For every 10 percent of stocks you hold, your portfolio’s value could decrease as much as five percent.
Stick to Index Funds
Indexes approximate the returns of different market segments. Often, an index will overlap neatly with an asset class you want to have in your portfolio.
Usually, the index consists of most of the significant securities that make up that asset class in proportion to their size. They normally go through yearly changes. Some securities are added, others fall out, and the weights of those staying in the index adjust to reflect their changes in value from the prior year.
With this said, an index is only an approximation of the actual returns for the asset class and tilt you’re looking for. But when the match is close, your best choice for the portfolio is a low-fee, tax-efficient index fund or ETF.
But there isn’t always an index fund available that matches your needs. And a tilt may also not have an index that properly tracks it. Take international small stocks and international large value stocks, for instance.
In these cases, you’ll need to find a low-fee actively-managed fund.
Know Your Required Return
Though it’s possible to create a portfolio with no risk, it won’t provide an adequate return. As a semi-retiree, your portfolio must grow against the following three forces:
- Inflation – about 3 percent
- Fees and trading costs – about 0.5 percent
- Your annual withdrawal – about 4 percent
Adding these demands on your portfolio, you need at least a 7.5 percent return to keep the real value of your portfolio intact.
To learn more about successful investing principles, check out Work Less, Live More.
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