After we understand investing risk, the next thing to focus on are ways to limit our exposure to it. To limit our exposure, we use an investment plan. Let’s identify the main elements of an investment plan. An appropriate plan will consider the uncertainty that Kahneman described in the following quote.
What hindsight does is it blinds us to the uncertainty with which we live. That is, we always exaggerate how much certainty there is. Because after the fact, everything is explained. Everything is obvious. And the presence of hindsight in a way mitigates against the careful design of decision making under conditions of uncertainty.
– Daniel Kahneman; 2002 Nobel Prize winner in Economic Sciences; Emeritus Professor, Princeton University (WSJ CEO Council; Wall Street Journal, R2; 22 November 2016)
A savings program should constantly place new funds into your investment portfolio and prevent the need to take money out of it. Many individuals help provide ways to improve this portion of our lives and a deep dive into their work is beyond the scope of this post. However, you can look them up if interested-Dave Ramsey and Suze Orman come to mind. The principles that one should focus on are these: lower your monthly outflows to free cash for personal savings by reducing debt obligations, create and maintain a rainy-day fund in an accessible savings account of at least three months’ expenses, and only then put money into an account for long term investment purposes.
When considering an investment savings program, make sure that the recurring savings is appropriate for your situation. One facing unstable employment should reconsider saving a large portion of their income unless they already have the security of a rainy-day fund. The more stable our situation became, the more we tried to push this number up. The goal is to commit between 10-15% of our household take home pay into an investment account after the rainy-day fund is completed.
ACTION ITEM: Before reading on, if you haven’t already started some form of recurring savings plan and you don’t have income issues-I implore you to set up a recurring deposit into some investment account. This account can be savings that will be used for real estate investment, stock investment, small business investment or paying down debts to free additional cash. However, this is so important to your investing future that if you don’t do anything else recommended in this blog, I will consider our interaction a success if you act now and commit to a recurring savings plan and follow it for the rest of your life.
Where and when to put funds to work
The first place to consider putting this money is into an employer funded retirement account like a 401(k) or other tax sheltered account. This is important because most employers will match a certain percentage of your savings commitment find out what this commitment is and make sure that the amount you contribute will take maximum advantage of their match program. The maximum match allows you to get immediate return on your investment that is usually unparalleled in any investment for example, some employers match 100% of contributions made into their 401(k). This is free money and typically is the equivalent of a raise for merely participating in the employer’s retirement account.
An employer’s retirement account may have poor options for the investor and it is important to note this when you participate. If this is the case with your employer-that they place their funds into accounts that are not as investor friendly as one would like, then take advantage of their match and then place the rest of your savings into a self-directed, tax-sheltered account like an Individual Retirement Account (IRA). Finally, if you leave that employer, make sure that you roll that money into a personal, self-directed IRA.
The past couple of decades have confirmed that one of the most simple and effective strategies is to match the market return of the S&P 500 by investing in Index funds. Ironically, this strategy was lauded by Benjamin Graham mentor to some of the greatest investors of our time like Warren Buffett and his partner Charlie Munger. Graham suggested that for the individual investor that does not have the time or perhaps the desire to pick individual stocks the best way to participate in the stock market would be to purchase shares of an index fund, thus bringing us to the first strategy one should consider.
Plan 1: Purchase shares of an index fund that matches closely the performance of the S&P 500 index using dollar cost averaging. Dollar cost averaging means that the investor places the same amount of money into a mutual fund periodically allowing purchase of more shares during market downturns and limiting exposure to purchasing shares when the market is up. This is the best set up and forget model and returns an adequate appreciation of principal for the investor.
ACTION ITEM: Become familiar with various mutual funds. A great place to start is an index mutual fund. The ticker symbols SVSPX and IVV are for index mutual funds you may find interesting. SVSPX is an actively managed mutual fund that attempts to track the performance of S&P 500. IVV also attempts to track the performance of the S&P 500 but differs as an exchange traded fund or ETF. Both index funds have pros and cons. When looking at the two funds, consider the differences they possess. How did they perform with relation to the S&P 500 and to each other? What are the fees associated with each fund?