How To Invest Efficiently

The real path. No gimmicks or short-cuts.

The real path. No gimmicks or short-cuts.

My past articles have been on many essential topics relating to life, work, savings and even relationships.   Those posts serve as preparatory work for getting into a serious topic in this article – on investing.   Before starting on our investing journey, it is clear that we should learn to save more and be sensibly frugal.   The next step is to understand what efficient investing is – nobody taught me this but I learned the hard way by making mistakes, which I hope you will avoid.  You are smart to learn from my past investment mistakes.  Efficient investing is an important concept that will make a huge impact on your future, easily adding over $100,000 to your retirement stash with no effort on your part!

First, kill the management costs

You cannot control investment returns, but you can and must control investment costs.   This is a vital part of investing efficiently.  As a target, I would recommend that you start with 0.25% of total portfolio as a maximum for expenses.  For a $5000 portfolio, this would work to annual investment expenses of just $12.50.  Following a ‘traditional’ portfolio of 60% stocks (VTSMX – total stock market index fund) and 40% bonds (VBMFX – total bond market index fund), here’s how the expenses would look.

Stocks:  $3,000  invested, expense ratio 0.16%, annual expense: $4.80

Bonds:  $2,000 invested, expense ratio 0.16%, annual expense: $3.20

Total: $5,000 invested, annual expense: $8.00 (0.16%).

This is an extremely good starting point (only $8 in annual expenses).   If the stock index returns 8% annually over long periods of time, and bonds, let’s say do 4%, then the weighted average return of both at the same 60/40 ratio would be 6.4% (without expenses).  Using the above example expenses of 0.16%, the return would be  6.24%.   On the other hand, if your portfolio had an average expense ratio of 1.19% as Morningstar’s 2015 research showed, your portfolio return would be 5.21%.   This difference adds up to a pretty penny over time.  Over a 20-year horizon, $5000 invested in the above index funds in 60/40 ratio would become $16,778.   On an average expense ratio of 1.19%, the same money invested over the same period would be worth only $13,807, a loss of $2,971.   Put another way, you would end up with 21% more money if you chose the low cost route.

These differences would compound in a way that would make the average cost portfolio far worse if you were putting in money every year.   A different formula applies here.

This formula is powerful, just like 10! Rocks.

This formula kills your average cost investment.

If you invest $5,000 every year for 20 years,  the low cost portfolio would grow to $188,744.   In the average cost portfolio, it would grow to only $169,047, a difference of nearly $20,000!  For regular savers over longer (30+ year) horizons, the difference can be over $100,000

So, if you want to take the first step towards efficient investing, costs matter….a lot!   How do you figure out these costs?  Pay close attention to the items named ‘fees’, ’12b-1′ and ‘management expenses’ in the prospectus of any mutual fund you have put money in.  Then, come back to this page and apply the formula above using your annual investment figure as the PMT and i as the annual return minus all listed expenses in your fund details.    You won’t know what the returns (before fees and taxes) will be but for the sake of calculating impact, you can assume 8% for an equity fund and 4% for an intermediate-term bond index fund.  

Don’t want to do all this?  Then, quite simply, take the portfolio expense target I recommended above (0.25%) and make sure all your investments have total expenses at or below this target.

The first step to efficient investing is to kill the costs, and decimate them to insignificance!  The percentages may appear small but they are huge in impact – for example, 0.5% is better than 1%, 0.1% is far better than 0.5%, and 0.05% or lower is also possible as you get better at killing costs.  The rest of this post would make better sense after you have achieved at least 0.5% or less in annual expenses in your investment portfolio.  

Next, get on the efficient frontier express!

Pummeling down your investment costs means you have won most of the battle!  Now that you have conquered costs, the next step is to focus on efficient return.   This part is often not clear to many but is important to understand.  We all know that risk and return are related.  Higher risk means higher expected return and vice versa.   A lot of studies have been done on the trade-off between risk and return in financial investments, leading to what is called the Efficient Frontier.  

The holy curve of investing!

Efficient Frontier:  The holy curve of investing!

This is the curve that many financial planners, academics and funds use to analyze where they are in their portfolio.  The horizontal axis is Risk (measured as volatility) and the vertical axis is Expected Return (in %age).  The extreme top right end of the curve represents a 100% stocks portfolio, one that has the highest risk and also, the highest expected return.   Every point along the curve has a decreasing allocation of stocks and increasing allocation of bonds which reduces volatility (‘risk’) but also, reduces expected return.   The ‘dots’ below the curve are all less efficient portfolios because for the same level of risk, you can get a better return (or) for the same level of return, you can theoretically take on less risk (volatility). 

Notice how the curve bends down and left for the most part but finally curves back a bit?  That’s because a 100% bonds portfolio is more risky than a portfolio having 20% stocks and 80% bonds and it also produces lower return.   In other words, the curving back part (bottom left) of the efficient frontier curve is actually not efficient.   The efficient frontier ends at the point where the risk is lowest, which is roughly equal to 80% bonds and 20% stocks.  Staying on the efficient frontier curve is critical to maximizing returns.  This is why successful early retirees like Jim Collins suggest putting 80%, if not more, into one Vanguard index fund VTSAX that charges just 0.05% in fees!

Where does cash fit in here?  It doesn’t! The moment you hold cash, you move away from the efficient frontier to below the curve, which, by definition, is inefficient.  In other words, holding cash makes the investment portfolio less efficient (like one of the dots in the figure).   Now, there are good reasons to hold some cash but not as an investment, but perhaps as a small ‘comfort’ holding outside your investment portfolio. Remember cash yields next to nothing so, the ‘comfort’ you seek will be a drag on investment returns. That’s the price you pay for playing safe.  This is why fellow bloggers like ERN hold no cash, even as an emergency fund.  

Lastly, Got Risk?

100% of TFR family’s investment portfolio is in stocks.  Yes, 100%.   Isn’t that too risky? Perhaps, if you define risk as the possibility of seeing lower balance in my account next year than now.   That’s not how I define risk.  A large number of experts in the mainstream finance community have created a huge fear-factor on risk.  True risk is not volatility, that is, the day-to-day changes in the stock prices or even year-to-year declines possible in some years (can be as much as 40% during recessions).  The real risk is not being able to fully finance your retirement due to increasing costs.  The real risk is not recognizing that the 100% stock portfolio gives the highest possible return on the most efficient frontier, and for that, you must learn to deal with wild swings in portfolio value.  The real risk is in paying a heavy price at the end for the comfort of having a ‘smoother’ ride during the course of your investment journey.  The real risk is in demanding certainty in investments when the whole business world (where most of human effort, efficiency and creativity are employed), by nature, is uncertain. The real risk is not recognizing all that human work to increase business profits has a better chance of succeeding than a fixed return on a guaranteed debt (bond) payment.   The real risk is not recognizing that fluctuating dividend income from a gyrating stock portfolio is the price you must pay for a having an inflation-adjusted income source in retirement while ensuring portfolio longevity. 

The table below shows the expected return and risk for my portfolio versus the benchmarks.   If you notice, despite being 100% in stocks, my portfolio has lower risk than a 100% total stock index (see the Historical Risk column below).   For such a large reduction in expected volatility (‘risk’), my compromise in expected return is only 7% (that is, 9.3% expected return vs. 10.02% expected, for 100% stock portfolio).   How did I get here even with 100% stock allocation within the efficient frontier? Wait for a future post to describe my investing process in detail!

Asset AllocationHistorical ReturnHistorical Risk
Current Allocation9.3%15.8%
Target Allocation8.7%13.6%
100% Bonds5.56%9.21%
100% Stocks10.02%19.99%

This table is automatically and freely available for anyone who uses Personal Capital.  If you are still looking for reasons to join, you can read this post or sign-up for free.

What I have summarized in this post is elaborated as a multi-part series on Stock Investing by fellow blogger Jim Collins.  It answers just about every question you may have about investing.   Read that to get a ground-up perspective on how simple investing is and there is really no excuse get started.

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17 thoughts on “How To Invest Efficiently

  1. earlyretirementnow

    Thanks for giving us a shoutout! Great post. Agree fully with the 100% equity allocation. Don’t sweat the short-term risk (which is very low right now anyway, VIX at 12%!!!). Lower returns in the long-run as a result of not taking enough risk in the short-term are a real, real concern.
    Very true about the impact of fees. Amazing how they accumulate and compound over the years. One other thing you might consider for future posts: Part of efficient investing is obviously *tax*-efficient investing. Can’t cover everything in one post, of course.
    Also nice expose of the efficient frontier. I haven’t really seen a good tool for computing the frontier for a portfolio with 3 or more assets. (It’s easy with 2 assets, haha!!!)
    I use Matlab (or its free GNU based version Octave) to compute and plot it. If you have any suggestions, I’d be interested to know more! 🙂

    1. TFR

      Thanks ERN. I deliberately excluded taxes because each one’s situation is so different and is, also dependent on where you live and how your earnings are generated. Perhaps I will cover this in the future. Yes, investment costs are absolutely ‘game-changing’ in the journey to FI. Efficient frontier is built on stocks/bonds and everything else is outside the curve, so it is not comprehensive to all asset classes. Even within equities, it relies on generic indexes. That’s why it is possible to get even more optimal with a 100% stock portfolio by choosing those equities in such proportion that reduces portfolio volatility while only marginally impacting the return as the table shows in my post. Matlab is a good tool that I also use occasionally. Thanks for checking in.

    2. Michael Melissinos

      To further improve the efficient frontier, you can add in non-correlated investments and markets.

      This means diversifying away from stocks and bonds.

      My belief is that many people simply run an efficient frontier with asset classes close to home – in this case, US stocks and bonds. But US markets may take a back seat to better performing markets like Asia over the next 50 years. Who knows?

      To protect against home bias, I overlay very long term trend strength filters that tell me to allocate more to stronger trending markets. Performance improves even further when adding non-correlated markets like commodities, currencies or even different strategies than buy-and-hold like trend following.

      1. TFR

        Michael, I understand your approach but in my expeienence, simple trumps complex allocation. Also, as we saw in the 2008-09 period, just when you need the poorly correlated assets to behave as expected, they do the opposite and everything declines together. Unlike 10-20 years ago, all markets and risk asset classes are much more globally connected and correlated. I also add REITs and international equities to diversify away from US but even then there is no guarantee during periods like 2008-09. Buy and hold works but we just need to be patient, so if you are getting passive income like dividends while buying and holding, then it makes the wait easier.

  2. The Green Swan

    Great summary TFR! Just like you, I’m also entirely invested in stocks. I have a few actively managed finds that have higher fees, but they’ve paid off for me historically. My view is so long as I don’t need the money in the next five years then I should invest it in stocks. That’s they only way I think there is to beat inflation over time, as you mentioned.

    Thanks for the post!

    1. Michael Melissinos

      Even with your “long” time horizon, stocks are not guaranteed to be higher in five years or even 10. Since 2000, U.S. stock markets have two 50% declines. In other global stock markets, some have been much worse (e.g. Greece).

      I wonder if you have a sell discipline in place just in case the next five years doesn’t look like the next five. Too often, I see people with no sell discipline, plan on holding for the next five years, then run into a big loss and then “have to” hold for the next 10-15+ years.

      My point is to be careful about all in on any investment, especially during a massive bull market and to have a strict sell discipline in place just in case the trend turns downward.

      1. TFR

        I agree in theory that good sell discipline helps, but the problem for most investors is to execute this trade correctly twice – first, when you sell and second, why you buy back in. There are some who sold off their financial assets in mid-2008 getting the timing approximately right, but are still waiting to get back in! Had they simply stayed invested, they would’ve been made whole and then some by early 2012. This is the problem with sell discipline if it not accompanied by a good buy discipline.

  3. Mr. PIE

    Good summary.

    I was listening to a Meb Faber podcast today on the way to work and I nearly crashed the car when he started to speak of the size of assets under management that have fees in excess of 1% and even 2%. It blew my mind. Simply shameful that this skimming is still taking place.

    Imagine every year to be told on your performance review that you would be getting 2% smaller award than your colleague who performed at a similar level. Not so nice.

    1. Michael Melissinos

      Sometimes a 1% difference in fees doesn’t matter as much as sticking to your plan. Only considering the cost, in my opinion, is not enough information to make a decision.

      Sometimes paying 2% for a better performing or non-correlated product makes sense.

      In this case, I assume you guys are talking about similar performing products and strategies where one advisor charges 1% and the other charges 2%. In that case, yea, I’d always go with the cheaper advisor. That’s a no brainer. But sometimes it may make sense to pay up for something better or different.

      1. TFR

        Michael, This is a myth and you know it! How many hedge funds/advisors that charge the 2/20 model actually deliver a better net return than the index? Even if there are a couple, an average investor wouldn’t even qualify to invest money in them. I will cover this in my next article. Fees matter a lot and that 1% difference you cite will magnify over long periods of time, especially in the ‘low return’ world for the next 10 years or so as many predict based on current market valuations and anemic global growth.

  4. The Money Commando

    Expenses are a large part of why I moved away from funds and towards direct stock investment. Not only can you keep fees unbelievably low (zero, in some cases), but you have more control over the taxable consequences of gains and losses.

    I wrote a whole article about it a few weeks ago – feel free to check it out and let me know what you think.

  5. ZJ Thorne

    One thing I love about my brokerage firm is the 200 indexes etc that have no fees to buy. Those also happen to be Total Market Indexes that are really efficient on their own. It’s not the greatest place for DGI, but if that is the route I eventually take, I just need to be smart about my purchases and buy in larger amounts so the fee ends up being comparably low.

    1. TFRadmin

      Nothing wrong with indexes. Starting with indexes during accumulation phase is the best strategy as your focus is on building assets. DGI can come later.

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