I’ve been reading The New Frugality: How to consume less, save more, and live better by Chris Farrell. I want to summarize his recommendations for personal investing, since they were good reminders for me.
An investing strategy has to be fundamentally founded on what you want. What are your plans, goals, and dreams? Figuring this out is the hardest part for me. Once you know what you want, you also need to ask: Do those plans require money now or later? How devastating would it be if the money didn’t come through?
You then structure your investments in a way that maintains a “margin of safety” for achieving those plans. For example, if you think something is going to cost you $10,000, plan to have $15,000 available when the time comes. Sometimes (usually?) things don’t work out the way you planned. If you have a margin of safety, you don’t have to worry about it.
If you have credit card debt, do everything you can to pay that off. The rest of this article assumes you have savings and only low-interest debt (college, mortgage) or no debt at all. (Using a credit card is fine, as long as you pay the full balance each month.)
Start by conceptually dividing your portfolio into a safe, short-term portion and a riskier, longer-term portion. The former is the money that you can count on; the margin of safety if you lose your job, for example. The rest is focused on long-term returns — accepting risk to achieve better performance.
One rule of thumb is to invest your age percent of your money in the “safe” securities. In other words, if you’re 26 years old, put 26% of your savings in investments with very low risk. You modify this heuristic up or down depending on when you want to use the money, how risky your job is, etc.
For the safe part of your portfolio, Farrell recommends:
- FDIC-insured CDs (get from your local bank)
- US Treasury-backed bond funds
- TIPS (Treasury Inflation-Protected Securities) in tax-deferred accounts such as Roth IRAs
TIPS funds protect you from inflation risk in exchange for slightly lower performance.
Avoid money-market funds. They are too risky for the “safe” part of your portfolio because they are not FDIC-insured.
Farrell supports buying CDs from “community development banks” and credit unions. These accounts are FDIC-insured, and all of the profits go back into the local community.
The rest of your portfolio goes into higher-risk securities. This includes:
- Low-expense stock market index funds
- Bond funds not backed by the federal government
Using a mixture of stocks and bonds increases your diversification somewhat. Historically, there have been 10-year periods when bonds outperformed stocks. But in the recession starting in 2008, both stocks and bonds did poorly. Investing 10-30% internationally also helps with diversification, though less and less (since the global economy is becoming so closely intertwined).
Very risky, high-interest bonds are not worth it. They could collapse during structural economic downturns.
Avoid mutual funds. Why? Study after study shows that actively-managed mutual funds, on average, perform no better than passive market indexes (such as the S&P 500). Sure, there are always some mutual funds that do particularly well in a given year. There are others that do awfully. It’s impossible to know which is which ahead of time. To maximize your return, then, the best thing you can do is minimize the expense ratios. This is best accomplished with index funds that don’t require much involvement from the fund managers. To find out the expense ratios of any fund, use the FINRA Fund Analyzer. An expense ratio of 0.3% is pretty good.
Farrell supports investing in “socially responsible” index funds. Historically, these have performed as well as regular full-market index funds. And they support the stock price only of companies who meet criteria related to labor standards, sustainability, etc. The important thing is to make sure the expense ratio is low. Start with Vanguard’s FTSE fund.
Buying individual stocks is gambling. It’s something you do for fun, with money that you don’t mind losing. Chances are, you can’t beat the market. But historically, a few people have beaten the market, most notably Warren Buffet. His strategy boils down to: “Buy one stock at any one time. The best one going. And when it’s no longer that, replace it by the new best.” If you do buy individual stocks, do so in a taxable account. That way, you get a tax write-off if you lose and only have to pay the low capital-gains tax if you win.
Rebalance your portfolio once a year to match your risk tolerance. You will also need to rebalance when life events cause your risk tolerance to change.
When in doubt, keep your investment choices simple.
Farrell readily admits to being a “conservative” financial advisor. More people are being financially conservative now because the recession scared or forced them into it.
But the better, timeless reason to use the conservative approach is that money doesn’t buy happiness. Rather, it buys security. Owning a million dollars doesn’t change your relationships, your beliefs, or your community. Money is best at giving you the freedom to make life changes and recover gracefully from life changes that happen to you. The essence of frugality is to keep your priorities straight.