Last time we discussed Putting the Simple Path to Wealth into Action. That post grew out of a comment/question from reader KLR and, as I described, this gave me a chance to review how The Simple Path to Wealth might be implemented.
For a quick Simple Path review:
Do simply this and you’ll wind up rich. Not just in money.
The investing part consists of two phases:
1. Wealth Building. This the time when we are working and saving/investing 50%+ of our income. Since stocks are the most powerful wealth building asset class, and since a Vanguard Index Fund is the best way to own them, VTSAX is the chosen tool to get us there.
2. Wealth Preservation. At some point we’ll want to focus on preserving what we’ve built. Typically, this comes when we begin to approach retirement. For some this might be around the traditional age of 65. For those that implement the 50%+ saving rate I suggest it could come much, much sooner.
For this phase we’ll add a couple more funds to smooth things out. (The details of this phase and the funds I recommend for it can be found in Post #9: What we own and why we own it.)
What we have then looks like this:
Phase 1: The Wealth Building Portfolio
100% = Stocks held in VTSAX
0-5% = Cash held in VMMXX (for upcoming expenses)
Phase 2: The Wealth Preservation and Building Portfolio.
75% = Stocks held in VTSAX (growth)
25% = Bonds held in VBTLX (deflation hedge)
0-5% = Cash held in VMMXX (for upcoming expenses)
With interest rates at record lows, you’ll notice both these approaches call for minimum cash. In fact, I don’t even include the percent for in in the totals. I keep mine in the Money Market Fund VMMXX and in my checking account.
Back in the good old days, when short-term interest rates were higher, money market funds like VMMXX routinely paid more interest than bank accounts. But now the reverse is true, making back accounts the better choice. Plus you get the FDIC insurance.
While stocks, and by extension VTSAX, are the most powerful wealth building tool available they are also very volatile. Before you take this step, I strongly advise you read my series on this starting with Stocks — Part I: There’s a major market crash coming!! Investing in VTSAX will make you rich over time, but make no mistake, it will be a wild ride. Yer gonna have to be tough.
But what if you don’t want to put up with the gut wrenching ups and downs of the market? What if you’d be willing to give up some performance to sleep better at night? Is there a smoother path for you?
Reader/commenter COMatt put it well saying “Recently, I have found I can stick to my strategy better if I see at least something going up. Am I crazy to think this? I feel like everything in one fund will really test my nerves especially early on when I have little emotional investing experience.”
Matt’s not crazy at all and, yes, there is a smoother path. It might get you there a bit more slowly, but that’s ok. What’s far more important is that you:
Spend less than you earn – invest the surplus – avoid debt
So what is the magical smoother path? Well, at the risk of being anticlimactic, it is simply this:
Implement Phase 2 from the start.
Remember, Phase 2 is designed for wealth preservation while still offering growth. Moreover, you can customize it. Want a still smoother, but slower, ride? Just increase the percent you hold in VBTLX, the bond fund. Want more growth? Increase your stock percent with more in VTSAX.
Now in implementing Phase 2 we’ve strayed into what is called Asset Allocation in the investment world. Done right, it is a very useful thing. But it requires a bit more work. Namely, about once a year, you’ll want to rebalance your funds. Many folks do this on their birthday so it’s easy to remember. So what the heck is rebalancing and how is it done?
Let’s suppose you choose the same 75%-25% allocation I use. On your birthday next year you take a look at your two funds. Perhaps stocks have had a bad year and VTSAX has lost value. In the process, it is now only, say, 65% of your portfolio. Meanwhile your bonds are now 35%. Your allocation has shifted. To rebalance you simply sell enough of the bond fund to return it to 25% and reinvest that money into VTSAX returning it to 75%.
In the process, over time, you will have in effect bought low and sold high, without having to predict what the market is going to do. This improves performance and provides the smoother ride. Most times, as reader Matt looks for, you’ll be able to point to something going up.
To be clear, this is not to say there will be no bumps. Sometimes both will head down and at other times they’ll march up arm in arm. But even then they’ll each drop or rise at differing rates.
Here at jlcollinsnh we know the advantages of keeping things as simple as possible, but most Asset Allocation strategies use far more than just two funds. The most common addition is an International Stock and/or Bond fund.
Next post, Stocks — Part XI: International Investing, I’ll talk about why I don’t feel the need to add these funds. I’ll also recommend the two best to use if you decide you want to. Shortly after that I’ll post telling you about Target Retirement Funds which offer asset allocation with minimal effort. We might call these the “Even Simpler Smooth and Simple Path.” Stay tuned.
For more check out: Stocks — Part VI: Portfolio Ideas to build and keep your wealth.
There you go.
Whether you choose the wild and powerful ride or smooth sailing — if you avoid debt, spend less than you earn and invest the surplus — Financial Independence will be yours. At that point you’ll need to worry about how to spend all the money your money is making for you. You might even want to start to Give Like a Billionaire.