Investing Made Easy

The best-performing investment type varies from year to year, and is not easily predicted. For this reason, financial advisors uniformly suggest diversifying (or spreading) investments among different asset classes. Asset allocation refers to how an investor distributes investments between stocks, bonds, and other alternatives.

Each of the major asset classes can be achieved in different ways. You can use a combination of any of the following:

1. Selection of individual securities – This is a lot of work, and requires financial analysis skills (or luck) that many do not have.
2. Mutual funds – For an investment management fee, an investment professional will select securities for you. The central question is whether the fund manager can beat the market in an amount that exceeds the mutual fund’s fees. A large number of studies demonstrate that practically no mutual fund beat the market after payment of the fund’s fees, particularly when the period of comparison continues for more than a few years.
3. Passive investments – Passive investing seeks to achieve what the overall market does, but at the lowest possible cost. This strategy recognizes it is nearly impossible to beat the market over the long term, so the emphasis changes to matching what the overall market is doing. One then obtains higher returns by minimizing costs.

Practically every independent study ever performed has found that the third option (passive investing with minimal costs) beats an array of mutual funds. Passive investing has the added advantage of being the easiest to establish and maintain.

However, regardless of which of these three methods is used, the asset allocation challenge remains. A large portion of financial planning focuses on determining an asset mix that is appropriate in light of (i) when you will need the money, and (ii) how much risk you can comfortably tolerate. These two decisions can be addressed with the following online calculators:

1. Risk tolerance questionnaire – The results of this interactive worksheet are used in the next calculator.
2. Investment allocation calculator – This interactive graph is intended for retirement (long-term) savings, so one must be careful when addressing shorter-term needs. For example, if you are investing savings for other purposes (like college), you must “fool” the calculator by changing the inputs. Specifically, if you use the calculator for a need other than retirement:

a. Because you will need the money sooner than when you die, use age 70 less the number of years until the money will be needed as your current “age”, and

b. Because your shorter-term time horizon makes you more vulnerable to market fluctuations, use a more conservative risk assessment, particularly as the time approaches when you need the money.

Once an investment allocation (from the above calculator) is determined, a passive investment strategy (which we recommend) can be obtained by using low-priced exchange traded funds, or ETFs. ETFs are quite similar to mutual funds in that they hold a variety of underlying securities, but ETFs are purchased and sold through a brokerage firm just like an individual company stock.

Stay away from the plethora of “fancy” ETFs that focus on narrow investment segments, and which also generally have higher costs. Instead, consider the following ETFs that follow more broadly-based indexes and have low costs (information as of February 2008):

Following the above approach will generate market-matching returns. Consequently, this approach will never let you win bragging rights with your neighbors and friends. The above approach also cannot guarantee success, since each of the above investments can lose money. However, if history is any indication, you will probably fare better with this approach in the long run than by following the latest investment craze.