How automating your portfolio will save you money
Reprinted courtesy of MarketWatch.com.
To read the original article click here
Even if you have the best investment strategy in the world, your strategy isn’t worth much if it doesn’t get executed. Fortunately, this problem is very solvable.
This column, adapted from a chapter in my book Financial Fitness Forever, is the fifth and final entry in a series that addresses the four most important choices every investor faces: where you put your trust, whether you’re going to try to beat the market, how you deal with risk and properly diversifying your portfolio.
Here, we’ll look at how you can put your investments on automatic pilot.
Leave your feelings out of it
Emotion-based decisions can make investors more comfortable, but they almost always hurt in the long run. You may know what you should do, but if you wait until you feel like doing it … well, if you have ever tried to be serious about dieting or exercising, you know what’s likely to happen.
Fortunately, the solution is relatively simple, relatively easy, and relatively inexpensive: Set up everything on automatic as much as possible: savings, rebalancing, withdrawals and more.
Part of your financial life is probably already on automatic. If you have a job or you collect Social Security, you probably have money automatically deposited into your bank account. If you have a mortgage, you probably have signed up for automatic payments.
Four ways to automate your financials
Let’s look at four things you can automate: savings, stock selection, rebalancing and withdrawals after you retire.
For an investor, the most basic task is saving money. But saving isn’t always easy, and if you wait until you’re sure you don’t have some other use or need for that money, it might never happen.
Fortunately, it’s easy to save automatically. Virtually any bank or credit union can arrange automatic transfers from checking to savings. If you own a mutual fund, you can probably set up an automatic investment plan, often known as an AIP. (One thing I like about this is it let’s you get some of the benefit from Wall Street’s insatiable desire to manage more of your money.)
The earlier you establish this habit of automatic savings, the better. If you’re not doing this already, it’s never too late to start. Putting your savings on automatic pilot is a welcome case where “the easy way” produces better results than the hard way.
This may sound odd, but you can automatically diversify your portfolio, or select the stocks you’ll own, through mutual funds or exchange-traded funds.
The way to do this is by owning index funds. An index fund will make sure you automatically keep up to date with individual stocks in an asset class.
So when some rapidly growing company is becoming more and more important, your index fund automatically makes sure you own more of it. And when some company is gradually dying or quickly imploding, your index fund automatically reduces your exposure to it.
Then there’s rebalancing, the extremely important chore that involves shifting your investments from one asset class to another in order to keep your overall risk in line with your needs.
Assume you want to keep 60% of your portfolio in stock funds and 40% in bond funds in order to achieve a certain mix of potential returns and potential risk. Then a big bull market comes along and your stock funds do very well. After a year or so, stock funds make up 75% of your portfolio instead of only 60%.
That’s good, right? Well, yes, and no. It certainly is good that you made that money. But now your portfolio has too much exposure to risk. To bring things back into line, you need to sell some of the stock funds and use the proceeds to buy more of the lower-risk bond funds. This is rebalancing.
To do this right, you should evaluate every asset class in which you’re invested, rebalancing large-company stocks with small-company stocks, U.S. stocks with international stocks, value stocks with growth stocks, and so on. That’s a daunting task, and not many people are willing to do it. Unfortunately, I don’t know of any software that will do it automatically.
I think the best way to rebalance your investments automatically is to have your financial advisor look at your account once a year and just make the necessary trades.
Alternatively, if your funds are within a single fund family such as Vanguard, you can call that company once a year and ask them to make the trades to bring you back into balance with your targets.
If you’re regularly adding money to your portfolio, you may be able to maintain the proper balance by directing your new investments to asset classes that are below their percentage targets. However, this won’t be very effective if your portfolio is a lot bigger than your contributions.
Eventually, we reach the point when it’s time for our portfolios to pay us, instead of the other way around. If you have to decide every month how much you will take out for living expenses, you’ll waste a lot of time and energy.
Here’s a better way: Once a year, evaluate your needs for the coming 12 months, then set up automatic monthly transfers into your checking account. Once this is done, you’ll know every month how much you have available to live on.
The mechanics of putting all these things on automatic is not difficult. But some people have a lot more trouble than others when they try to put their emotions on the back burner. That’s why I strongly recommend you have an advisor do it for you.
Once your finances are on automatic pilot, your decisions can become lasting policies instead of one-time turning points.
You’ll have less anxiety and more peace of mind. I believe that’s a win-win financial prescription.
To hear a reading of the chapter from Financial Fitness Forever on which this column is based, check out this podcast.
Richard Buck contributed to this article.