Let’s suppose for a moment that this is you—you are 25 and gainfully employed. You’re the proud holder of an emergency fund stashed with enough cash to cover three to six months of expenses, have no credit card debt and your employer automatically enrolled you in a 401k plan, deducting enough from your salary to get the employer match and putting your 401(k) stash (when you didn’t say how you wanted it invested) in a target date mutual fund.
For some millennials this scenario will sound like a far off dream, but for others it’s a happy reality. If it’s yours, it may be time to take charge of your financial future by deciding if the target fund makes sense for you, raising your 401(k) contributions or saving in other accounts. Building your own portfolio is way to optimize your savings for your unique goals.
These can be tough decisions. “Investing can be simple, but it’s never easy,” says Robert Stammers, director of investor education for the CFA Institute. One good approach is to start out by asking some basic questions of yourself — and perhaps the experienced investors in your life.
What are my goals? “Investing doesn’t happen in a vacuum,” says Stuart Ritter, a vice president at mutual fund heavyweight T. Rowe Price. “What drives the investing is the goal.” Think about what you are planning to spend on and when. A portfolio destined for a down payment on a house in seven-years will look different (and likely be kept in a different account) than money you’re saving to send your kids to college in 25-years. That down payment money, for example, will be easier to tap if you save it in a Roth IRA than in a 401(k). If the goal you’re saving for is two years or less away, Ritter suggests simply keeping the money in a savings account, rather than having to worry about the short term moves of the stock market.
What don’t I know? To drive a car you don’t need to understand transmission gear ratios, but you do need to know where the brake pedal is and how to steer. Similarly, to put your money to work you don’t need to understand options, how to short a stock or be able to quote from The Dodd-Frank Act. (Most Congressmen probably can’t either.) But it is helpful to have a feel for value and a handle on interest rates.
The Financial Industry Regulatory Authority’s Investor Education Foundation offers a five question quiz to test your financial literacy. Topics range from how to calculate interest earnings on a savings account to how bond prices react to rising interest rates. (Hint: they are inversely related.) If you can’t answer FINRA’s questions you may want to do more research. For aspiring investors who want to go beyond the basics Stammers recommends CFA Institute’s Claritas certificate. Designed for people who work in the financial industry but don’t make investing decisions, the program delves into the tools and ideas that make the fiscal world tick. (Tell us about other great educational tools here.)
What is my risk tolerance? William Shakespeare said it best (throughHamlet’s Lord Polonius), “to thine own self be true.” When financial pros talk about “risk” they often mean volatility — an asset’s propensity to rise and fall sharply — but that is not always the most useful measure for a young investor. By starting early you give yourself time to ride out a risky equities portfolio. (Assuming, that is, you’re saving for retirement and not that house downpayment a few years hence.) Conversely, because you have time, stable investments with lower annual gains can compound significantly over time–but the difference between the higher expected returns of stocks and the lower expected returns of bonds will compound too. In other words, you’ll pay a bigger penalty for being conservative over 40 years than you will over two.
Stammers recommends asking yourself, “How much am I willing to be exposed to in order to get the potential upside? Or how much am I potentially willing to lose in any given period in order to take advantage of what the market may bear?” You should also take note of how much loss you can bear emotionally. An aggressive allocation heavy in stocks will backfire if you panic and sell at the bottom. That’s why Forbes contributor Richard Ferri, a former fighter pilot whose Portfolio Solutions specializes in asset allocation of index funds, recommends you start with a more modest stock allocation and work up to the 90% or so most target date funds set for people in their 20s.
What should my asset allocation be for other goals? Let’s say you do want to buy that house in seven years. Ritter explains that his starting guideline would be:
Stocks: 60%
Bonds: 30%
Bank account: 10%
Bonds: 30%
Bank account: 10%
Ritter further recommends diversifying stocks into:
This breakdown will differ for different people, with different goals, time-lines and risk tolerances — but no self-respecting adviser would tell you to put all your money into a single stock, sector or even asset class. “The key point,” says Ritter, “is those different sub-asset classes respond differently to the same economic environment.” So diversification helps mitigate nerve wracking swings in a portfolio. (Don’t fool yourself. That doesn’t mean all your holdings can’t go down at once in the event of another economic crisis. But it does tend to reduce the severity of the swings.)
What tools are best for my goal? Over the years Congress and the financial industry have created a variety of accounts for distinct goals. For college savings we have 529s and Coverdell accounts; for health care, HSAs; and for retirement 401Ks, IRAs and Roth IRAs, among others. Specialized accounts can be important tools, but in exchange for tax deferred or tax free growth, you risk having to pay tax penalties if you need to use your money for another purpose. Before locking up money you may want for grad school, make sure you understand the withdrawal rules. You can withdraw money from an IRA, without penalty, to pay for education or a first home, but you can’t take it out of a 401(k) for those purposes. (You can read 11 ways to get at retirement money early without having to pay a 10% penalty here. The rules can be tricky and it’s easy to trip up.) But there are also some opportunities worth considering. For example, if you put money in a 529 college savings account for yourself, you can use it for graduate school, or, if you decide not to go, for you own kids in 20 years. Provided you do eventually use the pot for qualified education expenses, all the growth during those 20 years will be free of federal and state tax.
For more flexibility, you can open a regular old taxable investment account with T Rowe Price, Fidelity, Schwab, Vanguard, etc. — a visit to any of the institutions’ websites should make it clear how to get started.
All the big players offer online tools to help you make decisions about how to allocate your assets (based not only on your age, but your risk tolerance). But lots of new tools and sites have cropped up around the web that are designed specifically with the young investor in mind. Some of these have no or super low minimum investments and might better hold your interest. Motif Investing, for example, is an online broker built for investing in ideas. If you love online gaming and think it is a growing trend, for example, you can buy the Motif “Online Gaming World.” Motifs can hold up to 30 stocks around an idea, and are balanced by professionals.
How often should I check in? Expert opinion varies on how frequently you should check your portfolio– common answers are once a quarter, once every six months or once a year. As your investments gain value (hopefully) and pay dividends, your original asset allocation will shift so you may want to re-balance annually to bring your assets back in line with your original diversification plan. Rebalancing has the added benefit of forcing you to sell stocks when they’re up (and hence an outsized share of your portfolio) and buy them when they’re down (and have shrunk as as share of your holdings). If your goals change or your life changes you should revisit your portfolio and risk tolerance as well. But do resist the urge to readjust every time the market moves up or down.
To DIY, or not to DIY? Time, desire and knowledge are all necessary to successfully manage a portfolio. Once you’re up and allocated, managing your own investments shouldn’t take up many hours. But it does require you to know enough to come up with a reasonable plan and to have the discipline and confidence to stick to it.
Working with an advisor can keep you focused and save you from making stupid mistakes. But the help often isn’t cheap. Experts tend to suggestgoing with a fee-only advisor. While some advisors take a commission for what they sell you or a percentage of your gains, you pay fee-only planners a flat or hourly fee. You can also pay a fee for a one time plan.
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