The Bogleheads' Guide to Retirement Planning (24 page)

Market returns are out of your control as an investor, but many things are within your control that can greatly increase the odds of growing your portfolio over the long haul. Create an investment plan appropriate to your individual needs and stick to it. Lower your overall portfolio risk by diversifying as widely as possible. Keep the risk and reward characteristics of your portfolio in line by rebalancing when things drift too far from your planned allocation, and remember that
costs matter!
Every expense or fee that you pay is that much less your investments will return. Keep investing simple and you will be wealthier and happier for it.

Retirement is expensive, and you need a viable plan to achieve your retirement goals. Just like heading out on a cross-country road trip without directions and a map is foolhardy, you shouldn’t set out on your journey toward retirement without having a road map that lays out the route to your future. Your plan should balance your need, ability, and willingness to take risk. Previous chapters provided information on the different types of personal, employer, and employee investment accounts and other available products that can help along the way. This chapter focuses on creating the road map to a solid investment plan.

The most difficult part of investment planning is getting started, but it is also the most important. Start with a reasonable plan, and revise it later as necessary. If you start with a good plan, you will find it easier to continue to make good investment decisions. Most investors do this backward by starting with investment selection, usually choosing from lists of top-performing mutual funds. The portfolio gets pieced together with the flavor of the month. While these returns may appear tempting, does investing in an African gold fund or a U.S. real estate fund really fit into your long-term plan? Without first developing that plan, you begin the journey into your future by looking in the rearview mirror, almost guaranteeing that, like a car driven forward by using only the rearview mirror, your portfolio may well crash.

A good way to make and follow a plan is to write an investment policy statement (IPS). An IPS is simply a written document that defines your general investment goals and objectives. It describes the strategies you will use to meet these objectives, contains specific information on subjects such as asset allocation, risk tolerance, and cash requirements, and sometimes lists individual investments.

Every investor can benefit from having an IPS. It provides the foundation for all of your investment portfolio decisions and keeps you focused on longer-term objectives. It can provide a way to monitor the investment performance of the overall portfolio, as well as the performance of individual funds. If you are using a financial adviser, an IPS should define the relationship between you and your adviser. An IPS provides a reference to see whether your portfolio is achieving your stated goals and objectives. Any proposed changes to your investments can also be evaluated and reviewed against your overall objectives by using your IPS. An IPS can be referenced in those times when you need to bolster your long-term investment discipline to help you avoid overreacting to short-term market fluctuations.

Investors who don’t have a written policy frequently base decisions on day-to-day events and often wind up chasing short-term performance that may keep them from reaching their long-term goals. They also have more difficulty staying with a long-term asset allocation, especially during turbulent markets or exuberant times.

Sign your statement after you write it. If you share your financial decisions with somebody else, such as a significant other or financial adviser, both of you should sign it. Even if it is just your own statement, signing it expresses your commitment to the plan.

Here are sample investment policy statements, based on the Boglehead principles of investing. The Deferrals need to make annual adjustments to their portfolios because they do not have life cycle funds, which help automate the execution of investment plans, available to them. In the second example, Captain Susan Saver uses the excellent life cycle funds available to her. These investment policy statement examples are deliberately simplified; your own statement may well be longer because you may want to record your reasons for many of your decisions. These investors appear again as examples in Chapter 10.

Investment Philosophy:
We would like a well-diversified, moderately aggressive portfolio with the minimal cost for each asset class we invest in. We will manage it ourselves but would like to keep the management simple. We hope to retire in 10 years, when we both turn 60.

How Much to Invest:
We got off to a late start and need to invest 25 percent of our salaries, which is $2,500 a month. The money will be withheld from our paychecks automatically and invested in David’s 401(k) and Donna’s 403(b).

What to Invest in:
The investment options in David’s 401(k) are better than those in Donna’s 403(b), so we will max out David’s 401(k), including catch-up contributions, before investing anything above the 5 percent that Donna’s employer matches. Since we expect to retire in the 15 percent tax bracket and are in the 25 percent tax bracket now, the 401(k) and 403(b) are better for us than a Roth IRA would be.

We will allocate our ages minus 10 percent to bonds, and the equities will be 60 percent U.S. large-cap, 20 percent U.S. small-cap, and 20 percent foreign. We plan to choose the least expensive diversified options available for each asset class, which will initially be 40 percent bonds, 36 percent U.S. large, 12 percent U.S. small, and 12 percent foreign stock.

Donna’s entire 403(b) will be invested in the S&P 500 stock index fund, which is her only moderate-cost option. David will hold Vanguard’s Total Bond Index, 500 Index, Small-Cap Index, and International Growth, which are all low-cost and are the best choices available in his plan. The combined totals will fill our asset allocation.

Rebalancing:
We will rebalance to the target allocation, including the 1 percent increase in bond allocations, every July, which is during Donna’s summer vacation and David’s birthday.

Reviewing This Statement:
This statement will be reviewed whenever there is a substantial change in our financial situation and annually when we rebalance. If there are no substantial changes in our financial situation, we will wait at least three months between changing the asset allocation in this statement and actually implementing those changes to our investments. We plan to review any changes in this statement again at that time.

Investment Philosophy:
I would like a broadly diversified portfolio at minimal cost. It should also be as simple as possible to manage; I will trust professional management decisions about appropriate investments for someone born in 1979 who expects to retire around 2040.

How Much to Invest:
I am currently investing $500 a month, which is about 10 percent of my pay. I will maintain the same percentage every year as I get a pay increase and invest half my raise when I receive a longevity increase or get promoted.

My investment will go automatically to the TSP. If I am deployed to a combat zone and my pay becomes tax-exempt, I will invest in a Roth IRA instead up to the limit and will have the contribution withdrawn automatically from my checking account on the first of every month.

What to Invest in:
My TSP investments will be in the Lifecycle (L) 2040 Fund. My Roth IRA investments will be in Vanguard Target Retirement 2040 Fund.

Rebalancing:
As long as I use life cycle funds, rebalancing will be done for me automatically. If I choose to manage my own funds in the future, I will rebalance in January every year, setting my bond allocation to my age minus 10 percent and my international stock allocation to 30 percent of my total stock allocation. (This is approximately the allocation strategy of the L 2040 fund.)

Reviewing This Statement:
This statement will be reviewed whenever there is a substantial change in my financial situation and annually in January. If there is no substantial change in my financial situation, I will wait at least three months between changing the asset allocation in this statement and implementing those changes to my investments. I will review the changes in this statement again at that time.

Now that you have a plan, it needs to be implemented and followed. Invest your first dollars according to your plan, make future investments automatic, and protect against procrastination. Your IPS will serve as a reminder of the decisions you’ve made so that you can carry them out as appropriate. Human nature, procrastination, and overreaction are common causes for concern; a good plan will make it less likely that any of these failings will derail you. Automating your investing means you never have to ask about market conditions.
Now
is always a good time to invest automatically.

If you are not already regularly investing for retirement, the most important thing you can do is to get started now. Compounded growth is your greatest ally when it comes to reaching your investing goals. It is important to get started right away, even if you are not sure exactly what to buy.

Whether you are early in your career and a new investor, or a midcareer investor just beginning to focus on your looming retirement, when you get started with your investing plan is much more important than what you actually buy. Where you invested your first $5,000 probably won’t make that much difference to your final retirement income.

When you start a job that offers a 401(k) or similar retirement plan, contribute at least enough to get the full match from your employer. That is free money to you. If your employer does not match your 401(k) contributions, contribute to either the 401(k) or an IRA as soon as you are in position to contribute.

If you aren’t yet sure of your investing risk tolerance or are in the process of working it out, then start investing conservatively. Your first investment should go into something very safe, such as a money market or Treasury bond fund. Select a date, probably a few months in the future, when you will start moving to more aggressive investments. Follow your IPS and include that date in your IPS.

It is easier to avoid spending money if you don’t receive the money in the first place. A 401(k) type plan does this for you automatically by taking a fixed percentage or dollar amount from every paycheck and depositing it into your 401(k). Most investment firms allow you to make automatic investments in a similar way in any type of account. For example, if you plan to contribute $3,000 to your IRA annually, you could schedule an investment of $250 on each monthly payday. Making this an automatic part of your regular budget similar to mortgage payments is a very efficient way to save.

Unfortunately, Vanguard does not allow you to open an account with automatic investments. You must make an initial investment of $3,000 or more in most funds, and after that you can do automatic contributions. (The Vanguard STAR fund requires an initial investment of only $1,000.) Therefore, if you decide to have a Vanguard IRA, you would need to start it with $3,000, but then you could continue your future yearly $3,000 contributions by adding $250 a month.

When you receive a raise, consider increasing your 401(k) or IRA contribution by half the amount of the raise or until you reach the maximum allowable contribution amount. That way you are putting away at least half of the raise before you have a chance to spend it.

Paying yourself first by making regular contributions to your retirement account from every paycheck has a name: it is called dollar-cost averaging (DCA). DCA means investing an equal amount at regularly scheduled intervals. When you do DCA, you are buying in at the average price during the year, and that ensures that you will not be adding your total annual contribution at a market peak. One month you would buy a fixed-dollar amount when the market is down, and the next month you invest the same dollar amount when the market is up. By doing this, you lower your average cost per share.

You may decide to dollar-cost average a newly acquired large sum of money, such as an inheritance. If you have a large sum of money to invest, you may want to move the money that is going into equities in equal amounts over a period of several months. For example, if 80 percent of the money is going into equities, you might invest 10 percent of the total in equities every month for eight months. Many investment firms will let you schedule these transactions automatically.

The advantage of DCA is that you are more likely to stick with the plan because you will have gone through the market’s ups and downs with only part of your money invested. The disadvantage of voluntary dollar-cost averaging is that you are not fully invested in the market initially and may miss a strong rally. It is a tough call. The psychology of investing plays a critical role here. On average, you would be best off investing everything at once, since markets go up more often than they go down. However, if you are unlucky enough to be investing in the roughly one out of three years when markets decline, you are unlikely to find much comfort in the average. There’s no one right answer for everyone, so you’ll have to decide whether dollar-cost averaging or investing the entire amount immediately is best for you.

Even if you do decide to DCA, you should invest the entire amount that is going into bonds as soon as you start investing. High-quality short-term and intermediate-term bonds are unlikely to fluctuate in price enough to make DCA advantageous, so it is best to get the money in and start earning higher interest