Note to viewers: Filmed in late April 2015, this Morningstar presentation was part of Money Smart Week, a series of free classes and activities organized by the Federal Reserve Bank of Chicago and designed to help consumers better manage their personal finances.
Christine Benz: As we all know, there are a lot of ways that investors can find success. They can find success through picking individual stocks. They can find success through picking mutual funds. They can find success through using just a simple target-date mutual fund. There are lots of ways to get it done. But when we look across successful investors, we do see some commonalities among their habits, and that's what Adam and I are going to talk about tonight.
We're going to divide and conquer. Adam is going to discuss four habits of successful investors, and I'll discuss the last three. Toward the end of the presentation, I'll also share some model portfolios that we have been working on for Morningstar.com. In a lot of ways, we think these portfolios illustrate some of the habits that we'll go through during the course of this presentation.
So, let's get right into the presentation. Let's talk about, first, what is a successful investor? And I think, in lot of ways, it can be helpful to think about what isn't necessarily a successful investor. Investment success isn't necessarily beating the market. It's not beating Warren Buffett. It's not generating returns that are higher than your neighbors or your brothers-in-law. Really, the main thing when you think about investment success is [whether or not you were] able to reach your financial goals. So, for most of us, this will entail achieving a comfortable retirement. Are we on track to achieve a comfortable retirement? If we wanted to fund college for our children or grandchildren or maybe fund some continuing education for ourselves, were we able to achieve that? Or perhaps we have shorter-term financial goals--and many of us do. So, if we wanted to buy a new car or buy a new home or make some home remodeling, were we able to achieve those goals? So, fundamentally, the question of whether or not you were able to achieve your financial goals should be your measure of your own success as an investor.
Along the way, we want to make sure that investors get there through skill and not luck. A successful investor is someone who understands the basics of saving and investing, who understands some of the key habits that tend to lead to investment success, and also avoids some of the big mistakes and some of the bad habits that investors can fall into.
In addition, we also define investment success as whether or not you were able to achieve peace of mind along the way. So, even if you were, in the end, able to reach your financial goals or maybe save and invest a sum that was way more than you expected, were you able to sleep easily at night? Balancing risk with returns is certainly fundamental to investment success as well. So, when we think about investor success, these are some of the key things we think about as defining investment success.
I'm going to just quickly outline the seven habits that Adam and I will spend a little more time on during the course of this presentation. First of all, successful investors tend to "cheap out." So, they watch their investment costs every step of the way, because those costs can eat into their take-home returns. Adam will outline some of those investment costs and steps you can take to reduce them.
Successful investors also focus on the big picture and tune out the noise. There's lots of information flowing about the markets, and it's important--to the extent that you possibly can--to tune a lot of that out because, ultimately, it doesn't affect your investment success. Instead, successful investors focus on the big picture. Successful investors also know themselves. They know the role that behavior can play in financial decision-making, and they take steps to ward against some of those behavioral traps. Successful investors also build in discipline, and here Adam will talk about some ways that you can, in some respects, put your plan on autopilot to kind of build discipline into your plan.
Successful investors also multitask, and this is something I'll be talking about in the course of my portion of the presentation. How do you juggle competing financial goals? Because most of us, at every life stage, are juggling some competing financial goals. How do you set those priorities and determine the best use of your capital at any given point in time.
Successful investors focus on limiting taxes. Just as they focus on limiting costs in their investments, they also focus on limiting the drag of taxes. And I'll talk about some specific ways that you can do that in your own investment plan.
And, finally, successful investors keep it simple. They avoid overcomplicated strategies. They avoid tactical market-timing strategies. They avoid narrowly focused investment products and, instead, run streamlined investment programs. And that's what I think the model portfolios will nicely illustrate--the merits of running a streamlined portfolio. So, I'll share three specific portfolios for investors at various life stages that I think illustrate the virtues of keeping things simple.
With that, Adam is going to come up here and get into four of the seven successful investing habits that we'll talk about during the course of the presentation tonight.
Adam Zoll: Thanks, Christine. And thanks to everybody for coming out tonight. The first habit that we're going to be talking about is "cheaping out." How do you keep your investment costs under control so that you can heighten your returns? And it's important to understand that the money you're paying somebody to manage your money--to make investing transactions for you, buying and selling shares of stock, for example--that's all money that is basically coming off the top of your total investing return. So, you need to be able to identify what those costs are in order to try to limit them to the degree that you're able to.
So, when we talk about investing costs, we're talking about things like fund expenses, the expense ratio that a mutual fund charges to manage your money; brokerage fees, the fees you pay every time you buy and sell shares of stock and any maintenance fees that may be involved; advisor fees, what you pay a financial advisor to manage your money, especially if he or she is not earning their keep; also administrative costs, many plans--401(k) plans, for example--have a layer of administrative costs built into the process that can eat away at your returns--the same thing with, for example, a 529 college-savings plan.
Morningstar research has found that low-cost funds consistently outperform high-cost funds. Basically, funds that are charging you less are allowing you to experience more of the return of the underlying securities. I've got an example that helps illustrate this pretty well.
Here, we have a hypothetical Fund A and Fund B. These funds, for the sake of our discussion, are identical in every way. They own the exact same basket of stocks. The only difference is that one of them charges 1% per year as an expense ratio and the other charges 0.1% per year. For the sake of our scenario, we'll say that we're starting with a one-time investment of $1,000 and that the underlying portfolio of stocks is gaining 10% per year.
So, after the first year, you can see that the amount your money has grown isn't all that different. I think it amounts to maybe $90; but after five years, a gap starts to appear. The reason why is because of compounding over time. The less of your money that is being skimmed off to pay for expenses, the more you're keeping, and each time that is growing 10%. So, obviously, the more that you keep, the greater the amount that's growing and the greater the amount that's compounding over time. After 20 years, our initial investment is worth about $6,000 in the cheaper fund and a little more than $5,000 in the more expensive fund, which is a difference of about 17%. So, this really shows how choosing lower-cost funds can help boost the value of your investment over time.
Sometimes we use the phrase "cost-effective investing" with reference to using some of the low-cost funds, as we've been discussing, and how to get more bang for your buck in terms of your investment choices. One way to keep your investing costs low is by choosing index funds, which are usually cheaper than actively managed funds. And if you're not sure of the distinction between the two types of funds, index funds are funds that are basically tracking an index. The best-known index fund type is the S&P 500 index fund, which some of you may own in your company 401(k) plans, for example.
That fund is basically just replicating whatever the index holds. An actively managed fund is a fund in which a manager or a team of managers is actually choosing specific securities that they think are going to outperform the market or that meet a specific profile. So, you're basically making a distinction between stock-picking or bond-picking and just tracking the overall market.
Another important step to take for cost-effective investing is avoiding paying sales loads. Sales loads are upfront or backend charges that you may have to pay to invest in certain funds. We usually recommend that, if at all possible, investors look for what we call "no-load funds" that avoid these extra charges.
Another move that you can make for cost-effective investing is considering ETFs, exchange-traded funds, which are often cheaper than traditional mutual funds, even if they're investing in the same index. Most ETFs do track indexes, which is one reason they do charge so little, but one problem that can arise with ETFs is that you may have to pay a brokerage fee because ETFs are bought and sold just like stocks on a stock exchange. Therefore, you need to be careful; if you're going to be trading in and out of ETFs frequently, you may be paying a brokerage commission each time you do that. So, even if the ETF charges a low expense ratio, those brokerage fees can really add up and eat away at that cost advantage.
Using a low-cost brokerage is another great way to keep your expenses low. If you're paying $40 or $50 each time you trade a stock, you're probably paying more than you need to. These days you can probably find a brokerage that's going to charge you maybe $10 or less for each trade.
If you're using a financial advisor, look for one that is fee-only, by which we mean an advisor who does not work on commission--who's not getting a percentage for each investing product that they sell you. Instead, they may charge you a percentage of total assets under management or, better yet, a model that we like even more is a flat fee or an hourly fee. If you're the kind of person who only wants to talk to an advisor maybe once or twice a year, it may not pay to give that person a percentage of your total assets. It may be more cost-effective for you to pay a one-time fee or, again, an hourly fee.
Habit number two: [Successful investors] focus on the big stuff. So, these are some of the most important levers that you have at your disposal that can lead to a successful investing outcome for you. The first one seems obvious, but it's still worth mentioning: saving enough. The amount that you are able to save and sock away probably is going to determine how much you end up with, as much as anything else. One obvious example: How much do you choose to contribute to your 401(k) plan at work?
Another important lever is when you start investing. The earlier you start saving, the more time your money has to grow--as we just saw in our Fund A and Fund B example--and the less pressure you'll be under to catch up later. When I communicate with younger investors, they often say, "Well, I just don't have the money to invest, or my job isn't paying me enough, or I'm still servicing my student loans." What many of them don't realize is that they have a huge advantage over older investors who may be making more money and have more disposable income; that's the advantage of time. The earlier you can start, the more that compounding is going to take place. And even if you can't invest as much as you'd like in terms of a dollar amount, it's still better than nothing, and you are getting that huge advantage in terms of compounding over time.
Asset allocation is another important lever to use. Stocks, of course, tend to outperform bonds over the long run, albeit with more volatility. So, pick an asset allocation that is appropriate for your time horizon and risk tolerance and capacity.
Sometimes people use those terms interchangeably; but when we talk about risk tolerance, we're really talking more about how you feel about risk--how much risk can you stomach?--whereas risk capacity is more about your financial profile. You may have a huge nest egg and be able to withstand a lot of ups and downs in the market, but you may be the kind of person who just doesn't want to watch the size of your account shrink and grow dramatically. Therefore, your risk capacity may differ from your risk tolerance and vice versa.
Security selection matters also--which stocks and funds and other investment types you choose to use--but it's not as important as these other factors, such as the saving enough, starting early, and asset allocation.
To give you an example of the role that asset allocation plays, we have some sample portfolios. These are sample retirement portfolios that Morningstar puts together for investors of different ages. And you'll see here that, at age 35, the allocation to stocks is much greater than at age 60. The thinking being that a younger investor obviously has more time to ride out the market's ups and downs, whereas an investor who's closer to retirement probably doesn't want to be caught in a sharp market turn when he or she doesn't have enough time to wait for the market to maybe recover over time.
Habit number three, they know themselves. This, I think, is one of the more interesting elements of investing. It's sort of the psychological or behavioral angle. A few important questions to ask yourself: What has been your experience with money and investing throughout your life? Did you grow up in a household where saving and investing was encouraged? If so, then it may be second nature to you. It may be an obvious thing for you to do. If you didn't grow up with that as part of your experience, then it may seem like a foreign concept--something you don't know much about. You may need to take some extra steps to educate yourself so that you understand how investing works. You may need to try to cultivate some good saving habits within yourself.
How confident are you in your investing abilities? Maybe you're the kind of person who doesn't feel very confident at all about investing. You're intimidated by it. It sounds too complicated. The good news is that these days investing can actually be very simple. I'll give you a couple of examples. A total stock market index fund tracks an index that basically tracks the entire U.S. stock market. You can essentially own every single stock in the U.S. market by owning one single fund or ETF--that's about as simple as it gets.
Another great example: target-date funds, as Christine mentioned earlier. Many of you may be familiar with them through your 401(k) plans or retirement plans. A target-date fund is basically a fully allocated retirement system in one fund. And, of course, target-date funds are geared toward investors who plan to retire in a given year, and that allocation adjusts over time based on the needs of the investor.
So, again, both of those are examples of how you can really simplify and streamline investing by holding one fund or maybe packaging those funds with a couple other funds. And you can call it a day after that. It can be as simple as you want to make it.
The other side of the coin, of course, is being overconfident--thinking that you know more about what the market is going to do or more about investing than you really do. One thing that it's important to accept, I think, as an investor is this: No matter how much you know about investing, you don't know everything. You don't know everything that's going to happen with the market. Even if you've had a great run--you've bought some stocks low and you've sold them high and you feel like you're really on top of what the market's doing--that's a recipe for potential future disaster if you become overconfident and start making unwise investing decisions. So, it's really important to sort of stay within yourself. Even the best investors don't hit homeruns every time they bat--not by a long shot. There are plenty of strikeouts mixed in also.
How comfortable are you with risk? This is a key question for any investor to come to grips with. We happen to have had in 2008 a very dramatic and, some might say, traumatic market experience with the financial crisis when the market dropped very rapidly in a short period of time.
Think about how you as an investor dealt with that situation. Did you sell out of stocks after they had dropped and swear them off for years? Did you buy more stocks after the market dropped because you said, "Hey, these stocks are now selling at discounts?" By the same token, we've had some very strong markets in recent years. In 2013, for example, the market gained more than 30%. How did you react to that? Did you buy more stocks as the market was going up? Did you stay out of the market ever since 2008 and only then decided to get back in? And then for those of you who remember the tech bubble of the late 1990s, how did you deal with the tech bubble? Did you buy an unhealthy amount of tech stocks? Did you get burned when the bubble burst? All of these real-world experiences can inform your own knowledge about the kind of investor you are and your tolerance for risk.
Also, think about what kinds of money mistakes you've made in the past. And these don't have to be investing mistakes. These can be just financial mistakes that you've made. Have you fallen for get-rich-quick schemes? Are you subject to impulse buying? Have you taken on more financial risk than you could handle? If the answer is yes to these questions, these may be clues that you really need to watch taking on too much risk as an investor--that you are prone to a certain kind of behavior.
So, it's important to understand that in investing your instincts can work against you. One example of this is the herd mentality that we as humans have sort of wired into us. We hear that everyone else is making money with a certain kind of investment; it's only natural that we want in on the action. We don't want to be left out. We want to join in. Or, on the other hand, if everybody is selling out their investments--for whatever reason the market looks shaky and everyone is getting out--it's only natural to feel like you should go along. There is "safety in the herd." However, the reality in investing is that the herd can often lead you astray. The herd typically doesn't have its timing down, for one thing. It's often selling when maybe it should think about buying and buying when it should think about selling.
There's a well-known Warren Buffett quote: "Be fearful when others are greedy and greedy when others are fearful." That's a succinct way of describing how value investors go about executing that kind of a strategy; they want other investors to be fearful because that's going to mean prices are going to come down on stocks. They are going to swoop in and buy those stocks that are now underpriced. Then, consequently, when stocks become overpriced, they sell before those prices can correct back to their intrinsic value. So, I always like to keep this in mind when I'm making investing decisions.
More trading usually means lower returns. We talked about trading costs earlier and about those brokerage fees that can really pile up over time. But more importantly, Morningstar data, for one, show that investors are lousy at time in the market. We have a metric we use on our website; we calculate both a mutual fund's total return and its investor return. The difference is that the total return is how the fund would have performed for an investor who stayed in the fund for the full year.
The investor return uses fund flow data--money that's flowing in and out of the fund--to determine what the average investor actually experienced. And what we found is that with some funds--specifically those that are particularly volatile--investors are routinely piling into them as they're going up, and many of them are getting in just in time for the fund to head downward. By the same token, investors sell out of funds that have fallen in value and, therefore, miss out on a rebound that often follows. So, investors have notoriously poor timing as far as that goes.
Find a risk level that lets you sleep at night--something that you're going to be comfortable with. But playing it too safe is a risk also because your money may not grow fast enough, for example, to keep up with inflation. A lot of surveys show that millennial investors are really shying away from equities at a time when they really can afford to be in equities, and they can afford to ride out the potential ups and downs in order to enjoy greater long-term appreciation and compounding. The fact is, by not participating in the market, you're exchanging one form of risk--market risk--for another form of risk, which is inflation risk and having the spending power of your investments eroded by inflation.
If you are still not sure about managing your own portfolio, do consider contacting a financial pro. Just remember, again, to keep an eye on fees.
I have, at number four, building in discipline. As Christine mentioned, there are lots of different ways that investors can systemize these good habits that we're talking about. One, for example, is automating your contributions--a set-it-and-forget-it approach. This is probably something you've experienced if you participate in a 401(k) or 403(b) plan. With every paycheck, a certain percentage of your pay is channeled into your retirement account.
One of the best benefits of this approach is that the money never makes it into your bank account or into your wallet, so you're never tempted to spend it. It's taken off the top of your salary, and you don't have to worry about that temptation to use it for some other purpose. It also applies dollar-cost averaging, which is a positive behavioral way to invest. Basically, when you are dollar-cost averaging, you are buying a set amount of securities on a consistent basis.
The good thing about this system is that you're sort of blindly doing it, because you're probably not paying attention to the market and trying to time it and say, "I'm going to put more into my 401(k) with this paycheck and less during this paycheck." By dollar-cost averaging, you're essentially buying more shares when prices are low and fewer shares when prices are high.
Rebalancing your portfolio is an important piece of investing discipline. This can be automated as well, however; a lot of 401(k) plans will allow you to put in your desired allocation, and the plan will automatically rebalance if the allocation of the account falls too far out of line by whatever percentage you tell it.
Also, with regard to rebalancing, less generally is more. You really don't need to rebalance more than once a year. But if something extremely dramatic were to happen in the market, you might consider doing it more often than that. But studies have shown that rebalancing throughout the year is generally not as beneficial as rebalancing less often.
Another system that you can use, available with many 401(k) plans, is auto-escalation. So, let's say you want to contribute 10% of your pay, but you just can't swing it right now because you just need the money for other purposes. Try to increase your rates by one percentage point each year until you get to your goal contribution amount. When you get a raise, use part of that raise to also increase your amount. So, if you get a 3% raise, maybe devote 1.5% to your 401(k), and then you can still use the rest as part of your take-home pay and enjoy the benefits of that.
Avoid the temptation to dip into your nest egg. It can be really tempting when you see this pot of money just sitting in there that you know you can't touch until you retire; you might want to borrow from it or even withdraw some of the money. Statistics show that many people who borrow from 401(k)s do pay the money back, which is great, except there is an opportunity cost. By taking the money out, you are removing its exposure to the market and, therefore, the money is potentially missing out on any gains.
The same thing goes for an IRA--don't raid an IRA. If you have a true emergency--a true family emergency--and you have no choice, by all means, use these accounts; but if you can help it, I think it's usually best to not touch the money that's in these dedicated retirement accounts. Similarly, when you change jobs, don't cash out your 401(k). You will have the option to do so, but unless you're 59 1/2 or older, you will have to pay taxes on the money. It's usually, I think, a better idea either to keep the money in your new employer's retirement plan or to roll it over into an IRA.
With that, I'll call Christine back up.
Benz: Thank you, Adam. I'm going to go through three additional habits of successful investors. One of them is that they can multi-task: They can walk and chew gum.
Investors, really at any life stage, are juggling competing financial priorities and goals. Think about students just out of college. They might have college debt, and they may also want to start an emergency fund, because they've heard that they should have some money set aside instead of having to resort to credit cards. And they may also want to invest in their 401(k) plan for their first job. Young savers are juggling those priorities.
People in their peak earnings years, their 30s and 40s, may be juggling retirement savings--they know they need to save for retirement in earnest--but they also want to save for college for their children. Those are two competing financial goals.
And even folks who are getting close to retirement, who think they're in pretty good shape for retirement, may be asking themselves, "Should I make additional retirement plan contributions, or is it a better bet for me to pay off my mortgage?" That's a big one I often hear from pre-retirees.
Whatever our life stage, we've got to figure out, if I've got this set amount of money to invest each month or each year, what's the best use of my capital? How do I deploy that money in the smartest possible way?
We need to think about prioritizing those competing financial goals, and we also need to be thinking about, what is the highest return that I could garner on each of my "investments"? "Investments" I've got in quotes, because sometimes that can include debt paydown. Paying down debt, whether its credit card debt or your mortgage, is a guaranteed return on your investment.
When we think about prioritizing those competing financial goals, for most of us need to put our retirement savings at the top of the list. Unless we're one of that shrinking group of people who has a pension to fall back on in retirement that will fully fund all of our in-retirement expenses, most of us need to put our retirement plan at the top of the list. That's why it's so important every step of the way, even if you're a young accumulator in your 20s and 30s, to spend time thinking about whether, given your current savings rate, you are on track to hit what you'll need to have in retirement.
Retirement, unfortunately, is going to have to trump other maybe more fun or emotionally satisfying goals--even paying for college, as important as that is for so many families. Your child will be able to get a loan or may be able to find other sources of financing--whether it's working part-time in college or whatever it might be. Your child has more levers to pull to pay for college than you will when you hit retirement and you haven't saved enough.
For most of us, we've got to put retirement funding at the top of the list and check our retirement readiness along the way. There are certainly lots of great calculators out there on the web to help you do that. One I often direct people to is T. Rowe Price's retirement income calculator. I like it for a number of reasons, but one of the reasons I like it is that it's a holistic tool. It factors in Social Security and the tax treatment of various asset types.
It's also helpful to think about the best return on your investments. Assuming that you have competing financial priorities, stack them up one by one, and look at which of these investments are going to deliver the best ROI.
Let's show a couple of examples.
Say I have the choice between paying down a credit card bill and investing in a 401(k). Even if I'm a very young accumulator and I've got that 401(k) almost entirely invested in stocks, and I'm earning some nice tax breaks on my contributions, enjoying tax-deferred compounding on those contributions, and as my investment earnings grow, I won't owe taxes on them. Despite all of those positives associated with investing in that 401(k), you are going to be very hard-pressed to out-earn any credit card interest rate. Unfortunately for that accumulator who also has credit card debt, paying down that credit card debt will be the best use of his or her cash.
Realistically, if that investor also has matching contributions that his or her employer is making on his or her behalf, it might be sensible to multitask. Put enough into the 401(k) to earn those matching contributions while also simultaneously paying down that credit card debt.
Choice two, let's say you want to put some money in a cash account, maybe you're like me and you really value the safety of cash, and you are worried about emergencies even above and beyond the standard advice to keep about three to six months' worth of living expenses in an emergency fund. Maybe I'm thinking about putting money in my cash account, but I've also got a mortgage over here. I think about my own mortgage at a nice low interest rate. Well, actually pre-paying that mortgage--assuming that one of my goals is to pay down that mortgage over the time that I live in the home--pre-paying that mortgage is going to be a better return on my investable assets versus investing in that cash account that's yielding, if I'm lucky, 1% right now.
That's a head-to-head comparison that occurs in a lot of households. Think about the return that you will earn on that investment account versus debt paydown.
Choice three is actually a pretty easy one. Do I invest in a Roth IRA where I'm putting aftertax money into that account, but I'll be able to take tax-free withdrawals in retirement? Or do I invest in a plain old taxable account where I'm putting aftertax dollars into the account, but when I pull money out, I will owe capital gains taxes on any appreciation. In this case if I have not funded my Roth IRA, I'm better off doing that before I move on to my taxable account.
Juggling these competing financial goals, and looking at the best ROI every step of the way, is a great thing for investors to think about doing. Of course if you are investing, you also want to think about any tax breaks that are associated with a given investment account. That has the potential to enhance your return versus putting the money elsewhere.
Another key habit of highly successful investors is that just as they might focus on limiting their investment-related costs, they also focus on limiting their tax costs.
I want to quickly run through the tax treatment of some of the key investment accounts that many of you have. With a traditional 401(k) or IRA, typically you make a pre-tax contribution and you enjoy tax-deferred compounding as long as you've got the money inside that account. When it comes time to pull the money out of the account in retirement, you will pay ordinary income tax on your contributions because you didn't pay taxes on them in the first place, and also on any investment earnings.
With Roth IRAs, it's the opposite. Aftertax money is going into the account. You're enjoying tax-free compounding on the investment earnings, and then when it comes time to pull the money out during retirement, that money comes out on a tax-free basis.
For taxable accounts, you will put aftertax dollars into the account. If you are using some sort of a taxable brokerage account, a non-retirement account, aftertax dollars go in. You'll pay taxes on any income or capital gains distributions that come out of the account as long as you hold it, and then when you pull money out--whether you're in retirement or whether it's before retirement--you'll also owe capital gains taxes on the investment appreciation piece.
Key ways that you can limit the drag of taxes on these various investment accounts: One is, to the extent that you're still accumulating assets for retirement, take advantage of these tax breaks. The government gives us all tax breaks because it wants to encourage our savings for our own retirement. To the extent that you possibly can contribute the maximum allowable amounts, that's a great start.
There are breakpoints in terms of contributions. People making contributions to company retirement plans--whether 401(k)s, 403(b)s or 457s--if they are under age 50, they can put a full $18,000 into the account, and that holds true whether you're making traditional contributions or Roth contributions.
People who are over age 50 can put an additional $6,000 per year into those accounts. Those catchup contributions for savers over 50 start on Jan. 1 of the year in which you turn 50. You don't have to wait until your birthday.
The contribution limits are lower for IRAs. It's the same whether you're doing a traditional IRA or a Roth IRA: $5,500 if you're under age 50, and $6,500 if you're over 50. So take advantage of those tax-sheltered wrappers while you're in your accumulation years.
Also take advantage of tax diversification. Spread your money around across the different account types, because you don't necessarily know whether the tax bracket you'll be in when you're making that contribution is high or low relative to what it will be when you pull your money out.
Tax diversification is a great concept to practice when you're in your accumulation years--spreading your money across the big three account types. Make some traditional contributions, make some Roth contributions, and also make some taxable contributions, provided that you've maximized your contributions to the other account types.
Tax diversification is something that's not going to benefit you during your accumulation years, but when you're retired and actually pulling money out of the accounts, you'll really value the fact that you've got these assets that have different tax treatments. For example, if you find yourself in a very high tax year in retirement for one reason or another, you'll value the fact that maybe you've got some Roth assets that you can pull out without any taxes. You'll also value the fact that you have taxable accounts where you'll pull money out and pay just capital gains taxes versus ordinary income taxes.
Tax diversification certainly during your accumulation years, but especially in your retirement years, is a key concept, and it's definitely your friend as an investor looking to limit the drag of taxes.
If you have taxable accounts, invest carefully, because you want to reduce the drag of taxes on a year-to-year basis. You want to limit income distributions from your taxable accounts; you want to limit capital gains distributions. When we think of security types that tend to fit really well within taxable accounts, we think of index funds and exchange-traded funds. Adam mentioned them for their nice low costs, but they also tend to have low tax costs, especially for equity index funds and exchange-traded funds.
You'd want to favor municipal bonds versus taxable bonds to the extent that you have bonds in your taxable portfolio and you're an investor who's in a higher tax bracket--and here we're usually thinking of investors who are in the 25% or above tax bracket.
The final habit of successful investors is that they keep things simple. They don't overcomplicate with tactical trading strategies, market-timing strategies, too many moving parts in their portfolios.
This is a very difficult thing to practice, because in my experience Wall Street really sells against this message. Their message oftentimes is, "Investing is super complicated; you need us to help you."
My advice is, if you keep your portfolio streamlined, you keep it simplified, you can get away with a very simplified investment mix without necessarily having to pay someone to manage your portfolio mix for you. Simplicity is definitely your friend.
The media also sell against the message that less is more. When you think about CNBC for example--even though they have a lot of really good experts, in my view, on CNBC--they have a lot of airtime to fill, too. You've got a lot of people talking throughout the day about stuff that ultimately does not make or break or affect your personal investment plan in one way or another.
Less is more. Tuning out the noise is a valuable thing to practice as you are accumulating assets, as well as when you're in retirement.
I have just a few basic tips for keeping your financial plan simple. One is that, at Morningstar, we're big believers in what's called "strategic asset allocation." Basically that means that you set up an investment mix that makes sense for someone at your life stage and then you gradually make it more conservative as the years go by. You don't respond to big changes in the market environment; you don't shift to cash and bonds when things look scary. You don't go full bore with an all-equity portfolio when things are going well, as they have been recently.
Instead you practice only mild changes to your investment mix. You do as Adam advised, regularly rebalance: Periodically scale your winning holdings back and steer them to your losing holdings. But you don't make big shifts based on what you think will happen.
Generally speaking, when we look at the performance of tactical mutual fund managers--those who jockey around and use market-timing maneuvers--what we see is that they're not terribly successful. In fact, most of them don't outperform a very simple 60% equity/40% bond portfolio. My advice is, don't get too fancy in terms of managing your asset allocation mix yourself.
Also use investment types that give you a lot of bang for your buck, and that give you a lot of diversification in a single shot. We're talking about broad-market index funds and exchange-traded funds, or target-date funds (the set-it-and-forget-it funds). If you don't care to manage your asset allocation on an ongoing basis you can outsource to one of these funds to let them do the heavy lifting of asset allocation for you.
Or maybe just use a simple balanced or allocation fund. When I ask Morningstar readers what their favorite holdings are, one fund that comes up again and again is Vanguard Wellington. It's just a simple 70% equity/30% bond portfolio. It's not right for everyone; it might be too conservative for young accumulators. But in terms of a very simple investment holding, I think it really demonstrates nicely what I'm talking about. Keeping things simple, not creating an overwrought portfolio that is composed of a lot of moving parts.
It's also valuable to winnow down the number of accounts that you have and the number of providers that you deal with. Even if you're managing all this stuff online and you're not receiving physical statements, it's really valuable to be able to see your investments together under the roof of a single provider, or maybe a few providers that you have a lot of confidence in, versus having lots of little accounts here and there.
Tune out the noise of the financial media: I mentioned the merits of doing that earlier.
Checking up on your portfolio fewer times per year. Less is definitely more when it comes to this. The market has been really good. I personally have had a little more temptation to crack open my 401(k) and see how I'm doing. But generally speaking, the less you plug into the fluctuations in your portfolio--whether good or bad--the better off you'll be.
Also reducing your own trading. Try to limit your trading to maybe just once a year, where you do that rebalancing. You get in, see how everything is positioned, see if there are changes you need to make in your investment mix. Ideally you'd have parameters for how often you'll check up on your portfolio and how often you'll rebalance specified in some sort of an investment policy statement--a really basic document that says, my asset allocation mix is this. This is how often I'm going to check up on this thing. This is how often I'll make changes. These are the catalysts that I'll use when making changes.
I'm just going to run through some simple model portfolios for young accumulators. You can see in this particular portfolio, I think it nicely illustrates some of the principles that we've been talking about. This is an all exchange-traded fund, all index fund, portfolio, and I've included the tickers here for both fund types. The five-letter tickers are mutual funds, and the three-letter tickers are all exchange-traded funds. The basic complexion of this portfolio geared toward young accumulators is an equity-heavy mix. You can see that we've got the majority of this particular portfolio in stocks. We've also got a globally diversified asset mix--because it makes sense for all of us, but especially young accumulators, to have a truly global portfolio.
I will mention as a side note that we have some of these portfolios on Morningstar.com. They're part of our free website, so you can just search for "model portfolios." We have what are called "retirement saver portfolios" that are geared toward accumulators. We've got six retirement saver portfolios, and we have six portfolios geared toward people who are already retired. You can check those out if you'd like to see more detail on these particular portfolios and also how the asset allocation mixes change for people at various life stages.
This is the young accumulator portfolio: equity-heavy, globally diversified. And it also includes a small slice of commodities-tracking exposure. I would put commodities in the category of optional for accumulators--and really for folks at any life stage. It's going to add potentially a little bit of diversification to the portfolio, but it's a small enough position that it's not absolutely necessary. If a young accumulator wanted to go with an all-equity portfolio, that's just fine, too.
Stepping out a little bit on the age spectrum, you can see that the portfolio starts to encompass more safe securities. We have more bonds in this portfolio. But for a 50-something, we still have plenty of equity exposure. The idea is that this is a person who maybe has 30 years left in his or her life. He or she needs growth in that portfolio. It's not going to cut it to hold CDs or money market accounts or even bonds and earn just a 2% or 3% return that barely keeps up with inflation. Instead, what you really need is a portfolio that will deliver growth potential.
This portfolio still has ample stock exposure, still has ample foreign-stock exposure, but it is starting to encompass more in safe securities. So, we've got a little bit in a core bond product. We've got a little bit in short-term inflation-protected bonds, as well as pure short-term bonds. And just a little bit of commodities exposure--again, optional--to deliver extra diversification for this particular portfolio.
This is one of my bucket portfolios for retirees. This is something I've been working on a lot. The basic idea is that we've got a portfolio that's more or less stair-stepped by risk level. Down at the bottom, it has a cash component. That's there to meet near-term living expenses. Then for money for years 3 through 10 of retirement, we're owning primarily bonds in this particular portfolio. Then for the money earmarked for years 11 and beyond of retirement, that's primarily the high-growth equity piece.
The basic idea is that we've segmented the portfolio by time horizon. Even a retiree needs plenty of growth potential in the portfolio. He or she may have 20 or 30 years in retirement, so they need to make sure that their portfolios grow as well.
Again these model portfolios can be found on our website. The retirement saver portfolios, there are six of them, as well as six retirement bucket portfolios.
We've also been doing some back-testing and some performance tracking of these portfolios. The idea there isn't to say, look at how smart we've been in terms of picking just the right funds. Instead it's really there to demonstrate the logistics a decumulation for retirees--because, if you are retired, you know it's been a very difficult time if you're an income-focused investor to try to ring income from that portfolio. Yields are way, way down, so we created these total return portfolios to demonstrate how you can balance stocks in your portfolio with some of the safer stuff.
Thank you all for coming out tonight. We appreciate you being here.