Let’s jump right to the point. The way I’ve chosen to invest is by using low cost index funds (either ETFs or Mutual Funds), and rebalancing them periodically, in my case, annually.
What is a fund? A fund is a basket of stocks or bonds, possibly other investing vehicles. You buy the fund and the fund management company manages what investments are in that fund.
At its simplest, you could have only two funds: one in stocks, one in bonds. Both should be very diversified. The stock fund should be an S&P 500 index fund, or a “Total US market.” I actually prefer the total market funds to S&P. They diversify into more of the different “sized” stocks, like small- and mid- cap companies. The S&P 500 is all large cap stocks, the big ones.
It’s amazing when you think about it. In one transaction you can buy a piece of the entire US stock market, at very low cost, and with very little effort on your part.
The bond fund should be a similar broad index of US bonds. I admit it: I’ve never been crazy about bonds. They seem boring. And it’s true, they aren’t going to have the long term return that stocks do. But they also don’t have the risks that stocks do. That is not to say there is no risk with bonds, but they tend to not swing as wildly as stocks can.
Stocks and bonds tend to be non-correlated, also. That means, when stocks go up, bonds go down, and vice versa. It’s not always the case, but over time, this non-correlation smooths out your overall portfolio valuation, and dampens risk.
You’ll need to determine what % of your portfolio you want in stocks, and in bonds. This, again, gets pretty personal. It depends a lot on your own risk tolerance and your age.
As you get older, especially getting close to retirement age, less volatility in your portfolio becomes important. You don’t want your portfolio slashed just before you retire. That would not be a fun way to start things out. In fact, it could mean you need to change your plans, working longer.
Risk tolerance is also important here. Are you going to be able to stand it when the stock market drops precipitously? Or are you going to panic and sell at a low price? If it’s the latter, it may be better to have a higher percentage in bonds.
From what I’ve read, even the youngest, most risk tolerant investors should have at least 10% in bonds. I didn’t believe this just a few years ago. There is a concept called the “efficient frontier”. Somewhere between 10-25% in bonds is a sweet spot because it lowers risks without lowering expected long term returns all that much. By filling in the valleys of market dips somewhat, your losses are more controlled than they would be with a pure stock portfolio.
The BogleHeads site has a great example of a super simple 2 fund portfolio:
This page shows 40% in bonds. That’s a little higher than I prefer at my age. I’m at about 30% now. I still want a bit more return and am willing to accept the risk. We’ll see if I hold true to that the next time the market has a downturn.
A two fund portfolio is about as simple as this stuff gets. You really don’t need to do much at all. If you’re really not interested in investing, not really interested in reading much about it, this could be a good way to go.
However, you likely could get some long term benefits from adding more asset classes. That is, adding more funds that contain other asset classes.
You’ll need to rebalance the portfolio periodically, perhaps annually. That will be the topic of the next post.