- Diversify. The most important and first decision in investing is asset allocation, diversifying an investment portfolio across different asset classes and sub-asset classes – stocks, cash, bonds and alternative investments (such as real estate or other real assets). The asset allocation will determine the overall return and risk of a portfolio. The return should match as closely as possible a sufficient return to meet an investor’s goal while the risk should match their ability and willingness to take risk. By investing in multiple types of investments you take advantage of the fact they do not tend to move together (they do not all rise or fall at the same time). Within each type of asset class (e.g., stocks), you also want to be diversified. You want multiple baskets with multiple eggs in each basket. Just as broad assets classes do not move together, sub-asset classes (for example value versus growth stocks) can also move in different directions – not all will succeed or fail at the same time. If the portfolio risk matches the investors risk tolerance the investor is less likely to make emotional decisions which cause the average investor to underperform the average mutual fund over time.
- Be both Strategic and Tactical. It is important to have a long term plan including a strategic asset allocation that is based on expectations of future long term returns and risk. However, there needs to be some room for tactical adjustments when short term expectations differ from those long-term expectations. For example, when interest rates are expected to rise short-term you should consider being biased to shorter term bond investments. When the economy is going through different stages of the business cycle (contraction, trough, expansion, or peak) you should consider biasing your portfolio based on how different sectors perform in different environments. Being tactical is not the same as trying to time the market. It is best not to be all in or all out of any asset class at any time.
- Think Globally. Globally is not just geographic. Consider the broad-spectrum of investment opportunities. This included indirect investments such as ETFs and mutual funds as well as direct investments such as individual treasury bills. Sometimes it is best to get diversification through an indirect investment but other times direct investing can be done at a lower cost and with more precision. Consider both active and passive strategies. Passive generally works well and is the least expensive way to get exposure to an important investment factor (for example large capitalization growth stocks following an index). However, active or semi-active investing may be preferable in areas where a good index is not available or where markets are less efficient (for example small company value funds). You should also consider fundamental weighted indices and funds as typical market capitalization funds while seemingly diversified are often driven by the performance of a small number of the index components. Geography also matters. The U.S. represents less than 60% of global stock market capitalization. Most investors have a home country bias. This is justified somewhat by the depth and liquidity of the U.S. market, but you should have exposure to international markets both developing and emerging to diversify your stock exposure.
- Price and Value Matter. If you were buying a house to serve as a rental property you would make sure you are paying a fair price relative to other available homes as well as the cash flow you would generate from owning the property. Similarly, if you were buying a small business to operate you would consider the cash flow it will generate including expected future growth in those cash flows. The price you pay for any investment asset matters – it should be reasonable compared to other similar opportunities and the fundamentals of the investment including current expected cash flows and expected future growth in those cash flows. I prefer to invest in assets that are selling at reasonable prices relative to fundamentals This is sometimes described as growth at a reasonable price or strategic value investing – this is not the same as just buying investments because they are cheap. Some investments are of low quality or have declining opportunities and deserve to sell cheaply relative to their fundamentals.
- Cost Matters. Costs including commissions, other trading costs, bid/ask spreads, management fees and taxes all provide a drag on returns over time. Costs should be minimized relative to performance. If you are investing in a mutual fund or ETF with higher than the market cost leader, make sure the additional returns exceed the additional costs. Manage taxes like any other cost. Use techniques such as tax loss (or gain) harvesting to maximize after-tax return each year.
- Location Matters. Place your investments where they will generate the highest after-tax return, when feasible. This is most feasible when you have both taxable and tax deferred accounts of similar size. In general:
- Very low yielding assets held for liquidity or diversification (for example money market accounts in normal market situations) should generally be in taxable accounts where they can be easily accessed. Municipal bonds and municipal money market funds are a special case. They should always be in taxable accounts regardless of yield. They should not be placed in tax deferred or tax-exempt accounts as doing so would convert tax free income to taxable ordinary income.
- Assets generating mainly ordinary income and short-term gains taxable as ordinary income should generally be in tax deferred or tax-exempt accounts. For example, higher yielding bonds and real estate investment trusts.
- Assets generating mainly qualified dividends and long-term capital gains should generally be in taxable accounts depending upon the expected holding period (the longer the planned holding period the longer the tax deferral and more likely it should be in a taxable account). For example, stocks investments whether held directly or indirectly through ETFs or mutual funds.