Investing for Retirement: Core Asset Classes
In order to build a diversified portfolio, you must first select asset classes that have minimal correlation with one another. David Swenson, the Chief Investment Officer at Yale University, presents one of the best overviews of core and non-core asset classes for individual investors in Unconventional Success: a Fundamental Approach to Personal Investment. Here, we will focus on core asset classes. Continue reading Investing for Retirement: Core Asset Classes
Investing for Retirement: Passive Investing – Indexed Mutual Funds & ETFs
The only rational path for individual investors is to invest in passively managed index funds. For the reasons described here, active management is a negative-sum game. Index funds track the performance of a particular market benchmark (“index”) as closely as possible. They do this by buying all, or at least a representative sample, of the securities in the benchmark. Indexing now represents approximately 30% of all investment dollars. Index mutual funds have $2 trillion in assets. ETF index funds have a similar amount. Surprisingly, that means that approximately 70% of investment dollars are still in actively managed funds! Continue reading Investing for Retirement: Passive Investing – Indexed Mutual Funds & ETFs
Investing for Retirement: Actively Managed Investing
It is nearly impossible for active managers to beat the market over the long term after taking management expenses, transaction fees, taxes, and risk into account. Individual investors don’t have the time or resources to compete with institutional investors. The only rational path for individual investors is to invest in passively managed index funds. Continue reading Investing for Retirement: Actively Managed Investing
Investing for Retirement: Financial Market Efficiency
How can the financial markets be simultaneously both efficient and, occasionally, investors behave so irrationally? How is it possible for speculative bubbles to form? In the first week of a microeconomics course, college students are taught about supply, demand, and equilibrium pricing. For every investor buying a stock, betting that it will go up from a particular price per share, another investor is selling the stock, essentially making the opposite bet. Or, more likely, a computer algorithm. Continue reading Investing for Retirement: Financial Market Efficiency
Investing for Retirement: Behavioral Finance
Introduction Behavioral Finance spans a number of fields including economics, history, psychology, sociology, epidemiology, and communications. As far back as 1841, Charles MacKay described the “madness of crowds”. [ROBERT SCHILLER AND RICHARD THALER] Robert Schiller, a Nobel prize winning economist at Yale University, defines a speculative bubble as: a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person … Continue reading Investing for Retirement: Behavioral Finance
Investing for Retirement: The Efficient Market Hypothesis
A highly liquid market like the stock market functions as a gigantic prediction market. It reflects the combined judgment of all buyers and sellers based on all publicly available information about each stock. For all the investors that choose to overweight a stock, other investors must have an equal amount of underweight positions. Therefore, stocks trade at their fair value on exchanges. That isn’t to say that stocks trade at their correct price. The correct asset price is only known in hindsight. At any point in time, investors can be collectively mistaken: overly optimistic or pessimistic. Continue reading Investing for Retirement: The Efficient Market Hypothesis
Investing for Retirement: Controlling Your Costs
The greater your investment costs associated with financial intermediation, the less you ultimately receive in savings. These costs may include brokerage commissions, sales loads, management fees, financial advisory fees, bank trust department fees, advertising costs, and lawyers’ fees. You cannot beat the market because it is a zero sum game. Financial intermediation means that beating the market is a loser’s game. Continue reading Investing for Retirement: Controlling Your Costs
Investing for Retirement: Predicting the Future
No, you cannot definitively predict the future of financial markets, especially in the short term. However, you can project future outcomes in terms of their probability. These forecasts permit you to be better prepared for possible risks. A Monte Carlo simulation permits you to model real-life systems including the probability (i.e. the odds) of a variety of possible outcomes given specific assumptions about future conditions (i.e. constraints). Continue reading Investing for Retirement: Predicting the Future
Investing for Retirement: Recalling the Lessons of History
Even if you aren’t a history buff, you should have a basic understanding of financial history so that you aren’t surprised by ‘unexpected’ financial downturns. When these downturns inevitably occur, you will be able to stick to your long-term financial plan. Limiting your research to just the past 100 years, financial history evidences significant volatility for both stocks and bonds. Using recent history as a rough guide, you should assume that similar downturns will happen again in the future, even if you don’t know exactly when they will happen.
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Investing for Retirement: Time
Time is transformational. The longer the time that you hold your investments, the closer your portfolio’s actual returns will approximate their expected average. If your investment time is short, then higher return investments may be too risky due to variation in your actual returns. But, if your investment time is long-term, then you can consider higher-return, riskier investments because the variation in your actual returns will be closer to the expected average. Continue reading Investing for Retirement: Time
Investing for Retirement: Return
But in the long run, whether for an individual stock or the total stock market, the market return must equal the investment return. Speculative return becomes statistical noise. Basic economics governs. Therefore, you do not need to forecast the speculative return; you only need to compute investment return. Continue reading Investing for Retirement: Return
Investing for Retirement: Other Types of Risk
Previously, we discussed market risk. In addition, there are longevity & mortality risk, health risk, event risk, and tax & policy risk. Continue reading Investing for Retirement: Other Types of Risk
Investing for Retirement: Market Risk
Risk and reward are inextricably intertwined. In the long run, you are compensated for risk. But, don’t expect higher returns without higher risk. And don’t expect safety without correspondingly lower returns. Continue reading Investing for Retirement: Risk
Investing for Retirement: Compounding, Inflation & Real Returns
What is most important is not the dollar amount but the purchasing power of the money that you save. In other words, what your savings will buy when you retire. Expect inflation to destroy the purchasing power of your savings almost as fast as you build wealth, depending on your asset allocation. Continue reading Investing for Retirement: Compounding, Inflation & Real Returns
Investing for Retirement: Building Your Net Worth by Budgeting, Saving & Investing
Your first goal is to not spend more than you earn. In particular, do not carry credit card debt month to month. There is no point in trying to figure out how to maximize return for a given level of risk if you are in debt beyond your home mortgage (~4%) and low interest (1-2%) car loans. The reason for this is that you likely are spending more on interest for your loans and, particularly, credit card debt than you ever would recoup by investing an equivalent amount minus fees, taxes, and your high interest debt. Continue reading Investing for Retirement: Building Your Net Worth by Budgeting, Saving & Investing
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