We're going to divide and conquer. Adam is going to discuss four habits of successful investors, and I'll discuss the last three. Toward the end of the presentation, I'll also share some model portfolios that we have been working on for Morningstar.com. In a lot of ways, we think these portfolios illustrate some of the habits that we'll go through during the course of this presentation.
So, let's get right into the presentation. Let's talk about, first, what is a successful investor? And I think, in lot of ways, it can be helpful to think about what isn't necessarily a successful investor. Investment success isn't necessarily beating the market. It's not beating Warren Buffett. It's not generating returns that are higher than your neighbors or your brothers-in-law. Really, the main thing when you think about investment success is [whether or not you were] able to reach your financial goals. So, for most of us, this will entail achieving a comfortable retirement. Are we on track to achieve a comfortable retirement? If we wanted to fund college for our children or grandchildren or maybe fund some continuing education for ourselves, were we able to achieve that? Or perhaps we have shorter-term financial goals--and many of us do. So, if we wanted to buy a new car or buy a new home or make some home remodeling, were we able to achieve those goals? So, fundamentally, the question of whether or not you were able to achieve your financial goals should be your measure of your own success as an investor.
Along the way, we want to make sure that investors get there through skill and not luck. A successful investor is someone who understands the basics of saving and investing, who understands some of the key habits that tend to lead to investment success, and also avoids some of the big mistakes and some of the bad habits that investors can fall into.
In addition, we also define investment success as whether or not you were able to achieve peace of mind along the way. So, even if you were, in the end, able to reach your financial goals or maybe save and invest a sum that was way more than you expected, were you able to sleep easily at night? Balancing risk with returns is certainly fundamental to investment success as well. So, when we think about investor success, these are some of the key things we think about as defining investment success.
I'm going to just quickly outline the seven habits that Adam and I will spend a little more time on during the course of this presentation.
First of all, successful investors tend to "cheap out." So, they watch their investment costs every step of the way, because those costs can eat into their take-home returns. Adam will outline some of those investment costs and steps you can take to reduce them.
Successful investors also focus on the big picture and tune out the noise. There's lots of information flowing about the markets, and it's important--to the extent that you possibly can--to tune a lot of that out because, ultimately, it doesn't affect your investment success. Instead, successful investors focus on the big picture.
Successful investors also know themselves. They know the role that behavior can play in financial decision-making, and they take steps to ward against some of those behavioral traps.
Successful investors also build in discipline, and here Adam will talk about some ways that you can, in some respects, put your plan on autopilot to kind of build discipline into your plan.
Successful investors also multitask, and this is something I'll be talking about in the course of my portion of the presentation. How do you juggle competing financial goals? Because most of us, at every life stage, are juggling some competing financial goals. How do you set those priorities and determine the best use of your capital at any given point in time.
Successful investors focus on limiting taxes. Just as they focus on limiting costs in their investments, they also focus on limiting the drag of taxes. And I'll talk about some specific ways that you can do that in your own investment plan.
And, finally, successful investors keep it simple. They avoid overcomplicated strategies. They avoid tactical market-timing strategies. They avoid narrowly focused investment products and, instead, run streamlined investment programs.
[Following are some excerpts from the full presentation.]
The first habit that we're going to be talking about is "cheaping out." when we talk about investing costs, we're talking about things like fund expenses, the expense ratio that a mutual fund charges to manage your money; brokerage fees, the fees you pay every time you buy and sell shares of stock and any maintenance fees that may be involved; advisor fees, what you pay a financial advisor to manage your money, especially if he or she is not earning their keep; also administrative costs, many plans--401(k) plans, for example--have a layer of administrative costs built into the process that can eat away at your returns--the same thing with, for example, a 529 college-savings plan.
Habit number two: [Successful investors] focus on the big stuff. So, these are some of the most important levers that you have at your disposal that can lead to a successful investing outcome for you. The first one seems obvious, but it's still worth mentioning: saving enough. The amount that you are able to save and sock away probably is going to determine how much you end up with, as much as anything else. One obvious example: How much do you choose to contribute to your 401(k) plan at work?
Another important lever is when you start investing. The earlier you start saving, the more time your money has to grow--as we just saw in our Fund A and Fund B example--and the less pressure you'll be under to catch up later.
Asset allocation is another important lever to use. Stocks, of course, tend to outperform bonds over the long run, albeit with more volatility. So, pick an asset allocation that is appropriate for your time horizon and risk tolerance and capacity.
Habit number three, they know themselves. This, I think, is one of the more interesting elements of investing. It's sort of the psychological or behavioral angle. A few important questions to ask yourself: What has been your experience with money and investing throughout your life? Did you grow up in a household where saving and investing was encouraged? If so, then it may be second nature to you. It may be an obvious thing for you to do. If you didn't grow up with that as part of your experience, then it may seem like a foreign concept--something you don't know much about. You may need to take some extra steps to educate yourself so that you understand how investing works. You may need to try to cultivate some good saving habits within yourself.
The other side of the coin, of course, is being overconfident--thinking that you know more about what the market is going to do or more about investing than you really do. One thing that it's important to accept, I think, as an investor is this: No matter how much you know about investing, you don't know everything. You don't know everything that's going to happen with the market. Even if you've had a great run--you've bought some stocks low and you've sold them high and you feel like you're really on top of what the market's doing--that's a recipe for potential future disaster if you become overconfident and start making unwise investing decisions. So, it's really important to sort of stay within yourself. Even the best investors don't hit homeruns every time they bat--not by a long shot. There are plenty of strikeouts mixed in also.
Also, think about what kinds of money mistakes you've made in the past. And these don't have to be investing mistakes. These can be just financial mistakes that you've made. Have you fallen for get-rich-quick schemes? Are you subject to impulse buying? Have you taken on more financial risk than you could handle? If the answer is yes to these questions, these may be clues that you really need to watch taking on too much risk as an investor--that you are prone to a certain kind of behavior.
I have, at number four, building in discipline. As Christine mentioned, there are lots of different ways that investors can systemize these good habits that we're talking about. One, for example, is automating your contributions--a set-it-and-forget-it approach.
One of the best benefits of this approach is that the money never makes it into your bank account or into your wallet, so you're never tempted to spend it. It's taken off the top of your salary, and you don't have to worry about that temptation to use it for some other purpose. It also applies dollar-cost averaging, which is a positive behavioral way to invest. Basically, when you are dollar-cost averaging, you are buying a set amount of securities on a consistent basis.
Rebalancing your portfolio is an important piece of investing discipline. This can be automated as well, however; a lot of 401(k) plans will allow you to put in your desired allocation, and the plan will automatically rebalance if the allocation of the account falls too far out of line by whatever percentage you tell it.
Also, with regard to rebalancing, less generally is more. You really don't need to rebalance more than once a year. But if something extremely dramatic were to happen in the market, you might consider doing it more often than that. But studies have shown that rebalancing throughout the year is generally not as beneficial as rebalancing less often.
Avoid the temptation to dip into your nest egg. It can be really tempting when you see this pot of money just sitting in there that you know you can't touch until you retire; you might want to borrow from it or even withdraw some of the money. Statistics show that many people who borrow from 401(k)s do pay the money back, which is great, except there is an opportunity cost. By taking the money out, you are removing its exposure to the market and, therefore, the money is potentially missing out on any gains.
With that, I'll call Christine back up.
Benz: Thank you, Adam. I'm going to go through three additional habits of successful investors. One of them is that they can multi-task: They can walk and chew gum.
Investors, really at any life stage, are juggling competing financial priorities and goals. Think about students just out of college. They might have college debt, and they may also want to start an emergency fund, because they've heard that they should have some money set aside instead of having to resort to credit cards. And they may also want to invest in their 401(k) plan for their first job. Young savers are juggling those priorities.
Whatever our life stage, we've got to figure out, if I've got this set amount of money to invest each month or each year, what's the best use of my capital? How do I deploy that money in the smartest possible way?
When we think about prioritizing those competing financial goals, for most of us need to put our retirement savings at the top of the list. Unless we're one of that shrinking group of people who has a pension to fall back on in retirement that will fully fund all of our in-retirement expenses, most of us need to put our retirement plan at the top of the list. That's why it's so important every step of the way, even if you're a young accumulator in your 20s and 30s, to spend time thinking about whether, given your current savings rate, you are on track to hit what you'll need to have in retirement.
Another key habit of highly successful investors is that just as they might focus on limiting their investment-related costs, they also focus on limiting their tax costs.
I want to quickly run through the tax treatment of some of the key investment accounts that many of you have. With a traditional 401(k) or IRA, typically you make a pre-tax contribution and you enjoy tax-deferred compounding as long as you've got the money inside that account. When it comes time to pull the money out of the account in retirement, you will pay ordinary income tax on your contributions because you didn't pay taxes on them in the first place, and also on any investment earnings.
With Roth IRAs, it's the opposite. Aftertax money is going into the account. You're enjoying tax-free compounding on the investment earnings, and then when it comes time to pull the money out during retirement, that money comes out on a tax-free basis.
For taxable accounts, you will put aftertax dollars into the account. If you are using some sort of a taxable brokerage account, a non-retirement account, aftertax dollars go in. You'll pay taxes on any income or capital gains distributions that come out of the account as long as you hold it, and then when you pull money out--whether you're in retirement or whether it's before retirement--you'll also owe capital gains taxes on the investment appreciation piece.
Key ways that you can limit the drag of taxes on these various investment accounts: One is, to the extent that you're still accumulating assets for retirement, take advantage of these tax breaks. The government gives us all tax breaks because it wants to encourage our savings for our own retirement. To the extent that you possibly can contribute the maximum allowable amounts, that's a great start.
The final habit of successful investors is that they keep things simple. They don't overcomplicate with tactical trading strategies, market-timing strategies, too many moving parts in their portfolios.
My advice is, if you keep your portfolio streamlined, you keep it simplified, you can get away with a very simplified investment mix without necessarily having to pay someone to manage your portfolio mix for you. Simplicity is definitely your friend.
I have just a few basic tips for keeping your financial plan simple. One is that, at Morningstar, we're big believers in what's called "strategic asset allocation." Basically that means that you set up an investment mix that makes sense for someone at your life stage and then you gradually make it more conservative as the years go by. You don't respond to big changes in the market environment; you don't shift to cash and bonds when things look scary. You don't go full bore with an all-equity portfolio when things are going well, as they have been recently.
Instead you practice only mild changes to your investment mix. You do as Adam advised, regularly rebalance: Periodically scale your winning holdings back and steer them to your losing holdings. But you don't make big shifts based on what you think will happen.
Generally speaking, when we look at the performance of tactical mutual fund managers--those who jockey around and use market-timing maneuvers--what we see is that they're not terribly successful. In fact, most of them don't outperform a very simple 60% equity/40% bond portfolio. My advice is, don't get too fancy in terms of managing your asset allocation mix yourself.
Checking up on your portfolio fewer times per year. Less is definitely more when it comes to this. The market has been really good. I personally have had a little more temptation to crack open my 401(k) and see how I'm doing. But generally speaking, the less you plug into the fluctuations in your portfolio--whether good or bad--the better off you'll be.
Also reducing your own trading. Try to limit your trading to maybe just once a year, where you do that rebalancing. You get in, see how everything is positioned, see if there are changes you need to make in your investment mix. Ideally you'd have parameters for how often you'll check up on your portfolio and how often you'll rebalance specified in some sort of an investment policy statement--a really basic document that says, my asset allocation mix is this. This is how often I'm going to check up on this thing. This is how often I'll make changes. These are the catalysts that I'll use when making changes.
The first habit that we're going to be talking about is "cheaping out." when we talk about investing costs, we're talking about things like fund expenses, the expense ratio that a mutual fund charges to manage your money; brokerage fees, the fees you pay every time you buy and sell shares of stock and any maintenance fees that may be involved; advisor fees, what you pay a financial advisor to manage your money, especially if he or she is not earning their keep; also administrative costs, many plans--401(k) plans, for example--have a layer of administrative costs built into the process that can eat away at your returns--the same thing with, for example, a 529 college-savings plan.
Habit number two: [Successful investors] focus on the big stuff. So, these are some of the most important levers that you have at your disposal that can lead to a successful investing outcome for you. The first one seems obvious, but it's still worth mentioning: saving enough. The amount that you are able to save and sock away probably is going to determine how much you end up with, as much as anything else. One obvious example: How much do you choose to contribute to your 401(k) plan at work?
Another important lever is when you start investing. The earlier you start saving, the more time your money has to grow--as we just saw in our Fund A and Fund B example--and the less pressure you'll be under to catch up later.
Asset allocation is another important lever to use. Stocks, of course, tend to outperform bonds over the long run, albeit with more volatility. So, pick an asset allocation that is appropriate for your time horizon and risk tolerance and capacity.
Habit number three, they know themselves. This, I think, is one of the more interesting elements of investing. It's sort of the psychological or behavioral angle. A few important questions to ask yourself: What has been your experience with money and investing throughout your life? Did you grow up in a household where saving and investing was encouraged? If so, then it may be second nature to you. It may be an obvious thing for you to do. If you didn't grow up with that as part of your experience, then it may seem like a foreign concept--something you don't know much about. You may need to take some extra steps to educate yourself so that you understand how investing works. You may need to try to cultivate some good saving habits within yourself.
The other side of the coin, of course, is being overconfident--thinking that you know more about what the market is going to do or more about investing than you really do. One thing that it's important to accept, I think, as an investor is this: No matter how much you know about investing, you don't know everything. You don't know everything that's going to happen with the market. Even if you've had a great run--you've bought some stocks low and you've sold them high and you feel like you're really on top of what the market's doing--that's a recipe for potential future disaster if you become overconfident and start making unwise investing decisions. So, it's really important to sort of stay within yourself. Even the best investors don't hit homeruns every time they bat--not by a long shot. There are plenty of strikeouts mixed in also.
Also, think about what kinds of money mistakes you've made in the past. And these don't have to be investing mistakes. These can be just financial mistakes that you've made. Have you fallen for get-rich-quick schemes? Are you subject to impulse buying? Have you taken on more financial risk than you could handle? If the answer is yes to these questions, these may be clues that you really need to watch taking on too much risk as an investor--that you are prone to a certain kind of behavior.
I have, at number four, building in discipline. As Christine mentioned, there are lots of different ways that investors can systemize these good habits that we're talking about. One, for example, is automating your contributions--a set-it-and-forget-it approach.
One of the best benefits of this approach is that the money never makes it into your bank account or into your wallet, so you're never tempted to spend it. It's taken off the top of your salary, and you don't have to worry about that temptation to use it for some other purpose. It also applies dollar-cost averaging, which is a positive behavioral way to invest. Basically, when you are dollar-cost averaging, you are buying a set amount of securities on a consistent basis.
Rebalancing your portfolio is an important piece of investing discipline. This can be automated as well, however; a lot of 401(k) plans will allow you to put in your desired allocation, and the plan will automatically rebalance if the allocation of the account falls too far out of line by whatever percentage you tell it.
Also, with regard to rebalancing, less generally is more. You really don't need to rebalance more than once a year. But if something extremely dramatic were to happen in the market, you might consider doing it more often than that. But studies have shown that rebalancing throughout the year is generally not as beneficial as rebalancing less often.
Avoid the temptation to dip into your nest egg. It can be really tempting when you see this pot of money just sitting in there that you know you can't touch until you retire; you might want to borrow from it or even withdraw some of the money. Statistics show that many people who borrow from 401(k)s do pay the money back, which is great, except there is an opportunity cost. By taking the money out, you are removing its exposure to the market and, therefore, the money is potentially missing out on any gains.
With that, I'll call Christine back up.
Benz: Thank you, Adam. I'm going to go through three additional habits of successful investors. One of them is that they can multi-task: They can walk and chew gum.
Investors, really at any life stage, are juggling competing financial priorities and goals. Think about students just out of college. They might have college debt, and they may also want to start an emergency fund, because they've heard that they should have some money set aside instead of having to resort to credit cards. And they may also want to invest in their 401(k) plan for their first job. Young savers are juggling those priorities.
Whatever our life stage, we've got to figure out, if I've got this set amount of money to invest each month or each year, what's the best use of my capital? How do I deploy that money in the smartest possible way?
When we think about prioritizing those competing financial goals, for most of us need to put our retirement savings at the top of the list. Unless we're one of that shrinking group of people who has a pension to fall back on in retirement that will fully fund all of our in-retirement expenses, most of us need to put our retirement plan at the top of the list. That's why it's so important every step of the way, even if you're a young accumulator in your 20s and 30s, to spend time thinking about whether, given your current savings rate, you are on track to hit what you'll need to have in retirement.
Another key habit of highly successful investors is that just as they might focus on limiting their investment-related costs, they also focus on limiting their tax costs.
I want to quickly run through the tax treatment of some of the key investment accounts that many of you have. With a traditional 401(k) or IRA, typically you make a pre-tax contribution and you enjoy tax-deferred compounding as long as you've got the money inside that account. When it comes time to pull the money out of the account in retirement, you will pay ordinary income tax on your contributions because you didn't pay taxes on them in the first place, and also on any investment earnings.
With Roth IRAs, it's the opposite. Aftertax money is going into the account. You're enjoying tax-free compounding on the investment earnings, and then when it comes time to pull the money out during retirement, that money comes out on a tax-free basis.
For taxable accounts, you will put aftertax dollars into the account. If you are using some sort of a taxable brokerage account, a non-retirement account, aftertax dollars go in. You'll pay taxes on any income or capital gains distributions that come out of the account as long as you hold it, and then when you pull money out--whether you're in retirement or whether it's before retirement--you'll also owe capital gains taxes on the investment appreciation piece.
Key ways that you can limit the drag of taxes on these various investment accounts: One is, to the extent that you're still accumulating assets for retirement, take advantage of these tax breaks. The government gives us all tax breaks because it wants to encourage our savings for our own retirement. To the extent that you possibly can contribute the maximum allowable amounts, that's a great start.
The final habit of successful investors is that they keep things simple. They don't overcomplicate with tactical trading strategies, market-timing strategies, too many moving parts in their portfolios.
My advice is, if you keep your portfolio streamlined, you keep it simplified, you can get away with a very simplified investment mix without necessarily having to pay someone to manage your portfolio mix for you. Simplicity is definitely your friend.
I have just a few basic tips for keeping your financial plan simple. One is that, at Morningstar, we're big believers in what's called "strategic asset allocation." Basically that means that you set up an investment mix that makes sense for someone at your life stage and then you gradually make it more conservative as the years go by. You don't respond to big changes in the market environment; you don't shift to cash and bonds when things look scary. You don't go full bore with an all-equity portfolio when things are going well, as they have been recently.
Instead you practice only mild changes to your investment mix. You do as Adam advised, regularly rebalance: Periodically scale your winning holdings back and steer them to your losing holdings. But you don't make big shifts based on what you think will happen.
Generally speaking, when we look at the performance of tactical mutual fund managers--those who jockey around and use market-timing maneuvers--what we see is that they're not terribly successful. In fact, most of them don't outperform a very simple 60% equity/40% bond portfolio. My advice is, don't get too fancy in terms of managing your asset allocation mix yourself.
Checking up on your portfolio fewer times per year. Less is definitely more when it comes to this. The market has been really good. I personally have had a little more temptation to crack open my 401(k) and see how I'm doing. But generally speaking, the less you plug into the fluctuations in your portfolio--whether good or bad--the better off you'll be.
Also reducing your own trading. Try to limit your trading to maybe just once a year, where you do that rebalancing. You get in, see how everything is positioned, see if there are changes you need to make in your investment mix. Ideally you'd have parameters for how often you'll check up on your portfolio and how often you'll rebalance specified in some sort of an investment policy statement--a really basic document that says, my asset allocation mix is this. This is how often I'm going to check up on this thing. This is how often I'll make changes. These are the catalysts that I'll use when making changes.
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