There is a continuous debate that goes on in the context of investing through mutual funds.
Should I choose funds which are actively managed or choose Index funds which simply mirrors an index?
Some experts are strongly opinionated in favor of Index funds, whereas investment firms will always tout active investing for obvious reasons.
So what should we as investors choose?
Let’s see the different reasons why Index Funds are better choice for most investors.
Index Funds simply cost much lesser yet gives you the returns of the market.
Index Funds provide instant diversification from flavors such as Total market Index to specific themes and international market indices.
Index Funds do not have the need to reward performance and compete with other funds.
Index Funds do not need to trade very often, thus saving unnecessary tax liability due to capital gains.
Index Funds are simple to understand and follow.
So in an efficient market like the US, where information about good companies is widely available, beating the benchmark indices is not easy for fund managers. There are star fund managers who may have done that, but the percentage is very less, typically < 5%.
The simplest and most convenient in the US is the proverbial Bogleheads’ Three fund portfolio.
However the story may be different in other parts of the world, for example, emerging markets like India.
There are evidences of active fund management overtaking Index returns and in the short to medium term, even with the high costs of management, beat the index fund often.
However this is slowly changing and in recent years, the Index Fund is tilting to be the better choice for long term investors.
With more institutional money flowing into Index Funds as well, Fund managers will find it difficult to beat the index returns and the market efficiency will move towards that of developed markets like the US. To quote an article, it clearly shows the trend.
Over the last couple of years, many investors have increased exposure to index funds as returns from several categories of actively-managed funds failed to beat the Nifty 50 returns. In the past one year, the Nifty 50 has returned 12.51%.
If you are just starting off with organizing your personal finance, or restarting from scratch, here is a step by step way to get started.
Most of the times, we get started haphazardly, the first account in the local bank or the ad-hoc insurance policy or even the next stock tip forces us to open a brokerage account.
However there is a need to get started in a more planned way.
When I moved to the US couple of years back, the below is how I setup my money system. I had a similar one running in India for a long time and it has given me very good results.
Here is the starter kit that you need to get organized and get started.
Since it is built in a systematic manner, it will help you automatically organize and keep your finances in order.
A checking account
This is the first step as you need a place to deposit your income, be it direct deposit from your employer or you get checks at the end of the month.
Get a simple checking account at a Credit Union which provides you with a basic ATM and Debit card. Try to find a credit union or bank which has very low fees. Obviously they will have some like overdraft fees that we will anyway avoid, but others like ATM access are something unavoidable, so shop around a little.
This is where all your income will come in and get deposited.
A credit card
We are going to be responsible spenders, right? If not, do not get this and use your debit card from your checking account.
The key to being a responsible spender is to make a budget, stick to it and pay off the credit card bill in full every month. Lets just assume you agree to all of this.
There are many credit cards in the market with various features like cash back, travel rewards etc.
As a starter kit, you will just get one from the same bank or credit union where you hold your checking account. The reason is ease of payments and setting up automatic transfers from your checking account to pay it off at end of month.
The bonus will be of course if the card also has generous cash back benefits or other similar perks. But get a free one and not one with annual fee loaded just for extra perks.
The credit card will be your main expense vehicle. It gives you automatic fraud protection, insurance and easier account tracking.
If you do not do any further, you have setup the very basic system. You earn money which get deposited into the checking account, you spend with your credit card (on a budget!!) and your checking account pays it off every month.
But this sounds like living paycheck to paycheck or Living on the Edge, right?
We are going to do better – save and invest.
First what we need is a planner. As the above system of checking account and credit card gets working in a flow, you will start getting an idea of how much you are spending every month.
For the next 2-3 months, track your spending to categorize your money into only 4 parts.
Food and Dining
Utilities and Transportation
Clothing and miscellaneous
You will automatically get motivated to squeeze the first 3 categories and increase your surplus every month.
This is similar to Dave Ramsey’s first 3 baby steps, where you start with saving $1000, then get out of debt (hopefully you have none if you started with this) and finally build a cushion of 3-6 months of expenses.
I use an online savings account like CapitalOne 360, Ally Bank or Synchrony. There are many others, and online banks provide little more interest on your deposits than brick-and-mortar banks, or the one where you have your checking account.
Setup an automatic transfer of your Surplus from your checking account to this Savings account. Set this up for beginning of the month, so that your budget works with just the right amount needed (to pay off the credit card at end of month).
Get to this step only when you have a running budget, able to generate surplus consistently and stacked up 3-6 months of expenses in your savings account.
From here on, you become a pro in personal finance as you are about to invest and grow your net worth.
There are two main investment accounts, a retirement account and brokerage account.
Contact your employer for a 401k (Pretax or Roth) account and contribute to it, if there is a match. If this exhausts your projected surplus, no worries you have got started.
If there is still surplus, good news. Open a brokerage account in one of Schwab, Vanguard or Fidelity. Preferably open a Roth IRA account if your income is within eligible limits.
How are emotions and investments linked? Or should they?
The two are actually intricately linked in our financial lives.
Emotions define investments, and investments define emotions.
For example, most people who invest in stocks buy the next stock based on hot tips, be it from the last night party or the media channels doling out expert advice on stocks.
Or even the general euphoria about the economy and stock market makes us greedy and plunge into get-rich-quick behavior.
Thus an investment is made based on emotions for most people.
Now the same investments cause further emotions. The stock market is down, there is a trade war with China, the media is predicting a crash and so on.. We give in to the noise around us because we are now invested in the market, and it is our duty to become emotional with the world. Otherwise we are deemed too careless about the investments we made so emotionally.
Proven? – Emotions define investments, and investments define emotions.
However the above linkage can be controlled and severed at the right place to make it advantageous to long term investments.
There are only 3 steps to build a successful investment strategy.
Take your emotions into account in planning your investments and portfolio. See which areas of your financial life needs more focus, be it retirement, kids education, emergency fund or long term wealth. This is where most of the emotions should be used (as every one has different life goals and situation), but this is planning only – not yet buying any investment product.
Once you have decided what to invest in and how much, automate your plan. All banks and brokerage services provide automatic transfers and investments.
Take rest of your emotions elsewhere. Just forget the investments as they build up. You just need to tweak it once a year. However this is where people pour in maximum emotions as the noise in the market and the economy rise and fall. Instead hold your investments for the long term as if the account is locked, and you forgot the password.
What does investing mean to most people? Investing can be as complex or as simple as one wants to make it.
There are many theories for constructing a portfolio and it is not easy to ascertain which would work for one’s financial situation. Some common ones which are taught by most financial advisers are as follows.
Risk/return trade-off achieved with diversification.
Goal based portfolio – retirement, education, short term, passive income.
Age based asset allocation.
Robo advisor created portfolio.
The result is that one ends up creating multiple portfolios out of haphazard investments. The portfolios are also spread across multiple accounts as one’s financial life builds up.
As the accounts and portfolios spring up at different times, they lose the meaning of the overall asset allocation and financial goal of the person. There is no common theme or string to bind these accounts or portfolios together.
Here I present a 5 portfolio approach if you have multiple accounts and assign a meaning and goal to each. I have faced this dilemma and this solution/characterization comes from my own personal investment analysis.
This analysis assumes a person like me who is still 15-20 years from retirement, has children going to college in next 4-8 years and a starter in real estate and wealth building strategies.
P1: 401k – The All Equity Portfolio
Term: 15-20 years
Most working people will have a 401-k or IRA plan.
401-k has two very important kickers to deserve an All Equity portfolio.
Long term – You cannot withdraw money before age 59.5 without penalty. This forces you to be committed for long term, which is good for holding equity.
Tax deferred – The contributions and earnings grow tax deferred, hence can compound tax free for a long time (till withdrawn).
Hence it makes sense to hold a predominantly equity portfolio, since equity investments are known to minimize loss and provide best returns over a very long term.
For example, one can be invested in just 3 index funds in a 401-k. You can find similar funds in your own 401-k plan.
Large Cap Blend (Growth and Value) Index Fund
Small Cap Blend (Growth and Value) Index Fund
International Index Fund
If you have Roth 401-k or Roth IRA, treat them as same although the restrictions of withdrawal are slightly more flexible in a Roth IRA. See the link below for a discussion on the topic.
P2: Taxable account – The Diversification Portfolio
Term: 7-10 years
The second portfolio is also long term but not restricted. It is created to accumulate wealth and then use it for any long term purpose.
This gives one the flexibility to withdraw it for early retirement, kids college, medical emergency or any other unforeseen circumstances. Or simply to buy a new house or invest further into real estate.
This portfolio can be maintained in a taxable account with any brokerage firm. Although it is not tax deferred or tax shielded, it’s purpose is flexibility and use of the money in a medium to long term.
The characteristics of this portfolio is to hold a mix of different investments (low cost index funds or ETFs) which provide diversification across market caps, asset classes and risk/return profile.
It can also be optimized for tax savings if you design it that way, but then the goal is steady appreciation and not necessarily just tax savings.
This portfolio can be constructed using following types of index funds.
Total US Stock Market Fund (or S&P 500)
Total US Bond Market Fund
Emerging Markets Fund
Global Real Estate Fund
One can add more mix and diversification to this portfolio, for example, International Developed Markets Fund or a Commodity Fund.
If the 401-k already has a sizable allocation to International Fund, this portfolio may not have one but gravitate towards more exotic ones like Emerging Markets, Global Real Estate etc.
P3: Special accounts – The Stable Portfolio
Term: 4-7 years (or custom)
This portfolio is for special purposes like kids college savings, medical savings and so on.
These are some important and unique goals, which needs both appreciation yet reasonable capital preservation. In this portfolio to gain steady returns, there can be a perfect balance between equity and bonds.
For example, a 529 (kids college fund) and Health Savings Account portfolios can be simple:
Total Stock Market Fund
US Treasury Bond Fund
Typically a 50-50 allocation in two funds is good enough.
P4: The Daredevil – The Risky Portfolio
Term: 10+ years (longer the better)
This portfolio is not for everyone, but for people who are keen on more sophisticated investments in search of that extra kick (either the return or in your life).
This portfolio needs active monitoring and work to pick the investments. This portfolio has the potential for total loss, but at the same time may generate very high returns.
For example, these two accounts below can form part of this portfolio.
Fundrise – Real estate crowdfunding
Robinhood – Buy and hold individual stocks – dividend yielding and growth/value stocks at zero commission
However one can invest in a variety of similar high yield, high risk investments, for example, PeerStreet, YieldStreet etc.
P5: Cash Account – The Safety cushion
Term: 1-3 years
This is the most essential one to provide peace of mind. This account can be a high yield savings account or a FDIC insured money market account.
This portfolio serves two purposes.
Emergency Fund – This is typically 3-6 months of expenses stashed away for a rainy day.
Cash for next opportunity – This is money you save for down payment on a house, or next investment like buying a rental or invest more in stocks when the market tanks.
Any good online bank provides these savings account with reasonable yield.