Yesterday I received a call from an old friend seeking advice. He had recently done an analysis of his brokerage account statement and realized that he was paying thousands of dollars in fees each year. That, he said, represented a big chunk over 10 years or so that wouldn’t be going into college funds for his four kids and he had determined to leave his advisor and go it alone.
I told him that as our relationship was not a professional one with the appropriate oversight I couldn’t give him any specific advice, but that, as a friend, I could give him some general ideas of how best to set himself up. It occurred to me as I did so that there are probably many people like him out there; willing to give a self directed account the time and effort that it demands but unsure of how to structure one.
The first thing to do is to consider two aspects of your investing, time horizon and risk profile. Most wealth management firms have extensive questionnaires for new clients designed really just to assess those two things. In general, the longer the timeline that you envisage for your investments, the more risk you can afford to take on board.
Stocks, for example, tend to rise in price over time, but not in a straight line. You want to avoid the situation where a big downturn comes just as you are about to cash in your portfolio. With only a couple of years left until that point, therefore, it makes sense to skew ownership towards things such as bonds that tend to move less, but over time also return less.
Put simply, once you reach a certain point, the return of capital is more important than the return on capital.
Reducing the risk in your portfolio also makes sense if the normal ups and downs of the stock market give you the heebie-jeebies regardless of your time horizon. If opening your brokerage statement is a stressful event each month or quarter, then you should not be taking big risk on board, if for no other reason than that the stress that you feel can lead to you making bad decisions such as selling at the bottom of a move down when the stress becomes too much.
If, however, you can shrug your shoulders at the downturns and continue to invest then you need to understand that, in general, return is a reward for taking on risk.
In fact, logically speaking, for those that are investing a percentage of their income each month, those downturns should be seen as positive. They do, after all, enable you to buy stocks cheaply.
Once you have decided how much of your money to put into more risky assets in search of a return and how much you want to be safe, the next question is what to actually buy. Should you, for example go with individual stocks and bonds, mutual funds or ETFs? If you enjoy playing the market, by all means have a small percentage of your money set aside for individual stocks. Buying and selling them can be fun, but understand that most people get a worse return doing that than buying a diversified fund of some kind.
In general, the thing to keep in mind at this point is the KISS (Keep It Simple, Stupid) principle. Don’t get too elaborate, but focus instead on low fees and broad coverage. The “low fees” part of that leads me to a preference for ETFs over mutual funds where management fees are usually over 1%, and often much higher.
The safer portion of your funds, for example can be simply invested in one general bond ETF such as the Vanguard Total Bond Fund (BND) which has one of the lowest expense ratios at 0.06% and a yield (interest rate) of 2.55%.
The more risky part of the portfolio, though, is a little more complex.
Firstly not all of your “risk” money should be in U.S. stocks. Diversifying internationally through something like the iShares MSCI International Fund IXUS should account for around 20% of funds. The remaining 80% can be divided up in a couple of different ways. Conventional wisdom is to simply buy an index fund, something like SPY that tracks the S&P 500.
That is a good strategy as long as you are happy getting slightly less (because of fees) than the market’s overall return. There is one proviso, though. There is more than one index, and I would split between four, allocating around 30% each to ETFs for the big three, SPY, DIA (Dow Industrial Average), and QQQ (Nasdaq), with the remaining 10% in a Russell 2000 Small Cap fund. Again, Vanguard’s fund in that space, VTWO, offers low fees and good tracking of the index.
Once you are set up, though, the work isn’t over. Obviously the key to successful investing is to buy low and sell high, and by simply rebalancing your portfolio on a regular basis you can force yourself into that often counterintuitive behavior. Rebalancing involves doing what is needed to return your portfolio to its original percentages in each fund.
That, in turn, means selling the things that have over performed and buying those that have done less well, in other words, selling high and buying low. Doing that once or twice a year does generate some transaction fees but allows you to benefit from, rather than be hurt by, the market’s cyclical nature.
There are plenty of things beyond portfolio construction offered by a good financial advisor, such as detailed long term planning, but for those who are confident that they have those things in hand, a self directed account can be a viable option. Starting out running your own account can be daunting, but providing you have a road map such as that above to work with and the time to make the continued investments and occasional changes needed it can be managed fairly easily by most people and can save money that, with compounded returns, can make a big difference over time.