Asset allocation is the process of dividing your investment portfolio into different asset classes, or groups of investments. Each group offers unique characteristics that are defined by risks and returns.
Here’s what typical investors’ asset allocations—remember, that’s the mix of different investments—might look like as they get older. These figures are taken from Vanguard’s target date funds.
These allocations are just general rules of thumb. Some people prefer to have 100 percent in stocks until they’re in their thirties or forties. Others are more conservative and want some money in bonds. But the big takeaway here is that if we’re in our twenties and thirties, we can afford to be aggressive about investing in stocks and stock funds—even if they drop temporarily— because time is on our side.
And honestly, if you’re nervous about investing and just starting out, your biggest danger isn’t having a portfolio that’s too risky. It’s being lazy and overwhelmed and not doing any investing at all. That’s why it’s important to understand the basics but not get too wrapped up in all the variables and choices.
Over time, you can manage your asset allocation to reduce risk and get a fairly predictable return on investments. Thirty years from now, you’re going to need to invest very differently from how you do today. That’s just natural: You invest much more aggressively in your thirties than in your sixties, when you find yourself growing older and telling long-winded stories about how you trudged through three miles of snow (each way) to get to school every morning. The real work in investing comes with creating an investment plan that’s appropriate for your age and comfort level with risk.
All of this sounds completely reasonable: “I invest aggressively when I’m younger, and as I get older, I get more conservative.”
How the hell are you actually supposed to do it? What specific investments should you choose? Should you invest in individual stocks? (No.) Most people stop here, thinking that investing is only about stocks. Not surprisingly, when they try to think more deeply about this, they get confused and delay the decision to invest until someday in the future.
Don’t let this happen to you! Let’s go further up the Pyramid of Investing Options to cover another key to investing: funds.
Mutual Funds: Not Bad, Pretty Convenient, but Often Expensive and Unreliable
In 1924, mutual funds, which are just baskets filled with different types of investments (usually stocks), were invented. Instead of requiring investors to perform the Herculean task of picking individual stocks themselves, mutual funds allowed average investors to simply choose types of funds that would suit them. For example, there are large-cap, mid-cap, and small-cap stock mutual funds, but also mutual funds that focus on biotechnology, communication, and even European or Asian stocks. Mutual funds are extremely popular because they allow you to pick one fund that contains different stocks and not worry about putting too many eggs in one basket (as you likely would if you bought individual stocks), monitoring prospectuses, or keeping up with industry news. The funds provide instant diversification because they hold many different stocks.
Most people’s first encounter with mutual funds is through their 401(k), where they choose from a bewildering array of options. You buy shares of the fund, and the fund’s manager picks the stocks he or she thinks will yield the best return.
Mutual funds are incredibly useful financial tools—over the past eighty-five years, they have proven to be very popular and extremely profitable.
I put my first chunk of money in an actively managed fund about a year before I read your book and really began to understand mutual funds. It was a long-term investment, so it certainly made money, but when compared to a benchmark index fund, I missed out on some growth. I finally found myself at a point where paying capital gains tax made sense, so I’ve now been able to roll it into lower-cost investments. Thanks, Ramit, for showing us the light.
—ANAND TRIVEDI, 35
Outlook for Mutual Funds
Compared with other investments, they’ve been a cash cow for Wall Street. That’s because in exchange for “active management” (having an expert choose a fund’s stocks), the financial companies charge big fat fees (also known as expense ratios). These fees eat a hole in your returns. For what? For nothing! You don’t need to pay that! Sure, there are some low-fee funds out there, but most mutual funds have high expense ratios.
Now, I don’t fault the financial companies for selling mutual funds. They got average Americans to invest, and, even after fees, mutual funds are an excellent investment choice compared with doing nothing. But things have changed.
Advantages of a mutual fund: Hands-off approach means an expert money manager makes investment decisions for you. Mutual funds hold many varied stocks, so if one company tanks, your fund doesn’t go down with it.
Disadvantages: Annual fees can equal tens of thousands of dollars or more over the lifetime of an investment by using expense ratios, front-end loads, and back-end loads (worthless sales charges that add nothing to your returns) —all tricky ways to make mutual funds more money. Also, if you invest in two mutual funds, they may overlap in investments, meaning you may not really be as diversified as you think. Worst of all, you’re paying an “expert” to manage your money, and 75 percent of them do not beat the market.
In short, mutual funds are prevalent because of their convenience, but because actively managed mutual funds are, by definition, expensive, they’re not the best investment anymore. Active management can’t compete with passive management, which takes us to index funds, the more attractive cousin of mutual funds.
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