One of the most common complaints I hear as a female financial advisor is that investment jargon (ETFs, P/E ratios, DRIP plans, etc.) is…. boring, confusing, and overwhelming.
I’m happy to tell you it doesn’t have to be that way. To stop the buzzing in your head, simply apply the 80/20 rule (aka Pareto’s Principle). In plain English, the 80/20 rule states that in most situations, 80% of the outputs are driven by 20% of the inputs. Real life examples: 80% of the time you wear 20% of your clothes; 80% of the meals you cook are from the same 20% of your recipe collection.
I’d argue “80/20” applies perfectly to investing as well. Most (yep, probably 80%) of your long run financial success will flow from your understanding of these three simple factors: asset allocation, fees and performance. Here are some questions to guide you.
(1) What is my asset allocation?
The mix of stocks, bonds, hard assets, and cash that you create (a process called “asset allocation”) is perhaps the most important investment decision you can make. Academic studies suggest that asset allocation is the defining driver of long run performance, explaining roughly 90% of a portfolio’s variability over time.
My favorite asset allocation rule of thumb comes from Vanguard founder John Bogle. He suggests the optimal bond-to-portfolio percentage is your age: for example, if you’re 40, commit 40% of your portfolio to bonds and 60% to stocks. Of course, you’ll need to allow some wiggle room to accommodate your personal circumstances (and stomach for portfolio gyrations), but this is as good as any place I’ve seen to start.
(2) What are the total fees am I paying?
Even a small increase in portfolio maintenance fees can have profound consequences. For example, over a 30-year period, assuming 6.5 percent compound annual returns, each additional 1% in fees would reduce the ending value of your portfolio by 25 percent. It’s hard to keep calm in the face of that number.
Fees can come in many forms. If you work with a financial advisor, you may pay her or him a percent of assets under management, commissions, or an hourly fee. If you invest in mutual funds or ETFs, you will pay underlying expense ratios. (Note: As I mentioned in a prior piece, “actively” managed funds almost always charge higher fees than “passive” index-like funds, despite a wide body of evidence that they don’t consistently beat the market.) Other types of fees can include commissions, trading spreads, loads, and even tax consequences.
The vital fee to focus on is the “all-in” fee. If you work with an advisor, be sure to find out what the advisor will charge, and which additional fees will be incurred by the investments he or she is steering you towards. I suggest keeping all-in costs to 1.4% or less by working with an advisor who focuses on index-like strategies. By contrast, many active portfolios can have total fees north of 2.5% (generally 1% for the advisor and 1.5% in active funds fees; again, be sure you focus on total all-in costs).
Of course, the “bargain basement” cost approach is to use index funds on your own. Bear in mind, though, that a single bad decision on your own can wipe out way more in principal than what’s represented by the 1% you’d pay to the right advisor.
(3) What has my performance been?
If you’ve set the right asset allocations and your fees are low, you don’t need to review your portfolio every month, unless that just makes your heart sing. I am, however, a big believer in closing each year with a review of your portfolio’s annual and inception-to-date performance. Why? So you can see if you need to make any changes to either your annual rate of saving or spending.
This is especially true once you reach retirement. Even if you’re following the truly 4% rule of thumb (spending 4% of your portfolio a year, adjusted for inflation), academic studies show that adjusting spending downward after particularly tough years in the markets can go a long way toward increasing the odds you won’t outlive your spending.
Learning to ask – and answer – these three investment questions can go a long way towards reducing money stress and increasing your “MoneyZen”!