In personal finance, simple is almost always better option
The financial industry loves to sell complicated — and expensive — products, but simple is quite often the smart choice.
You know all about the value of diversification.
The simplest approach to diversification is to own a mix of stocks and bonds. At the other extreme is a portfolio that owns a dozen or more types of asset classes, such as commodities, alternative investments and real estate, both here and abroad.
A recent analysis by Callan created a simple hypothetical portfolio for a 45-year-old saving for retirement. The portfolio contained only the S&P
500 stock index and the Bloomberg Barclays U.S. Aggregate bond index.
Over a 10-year stretch, that boring approach delivered a higher return and less risk than a more complex portfolio holding two-dozen asset classes.
While 10 years is a short time period, and we know that past performance is not a guarantee of future performance, the data suggests that getting basic diversification right (an age-appropriate mix of stocks and bonds) is the big win. Adding all sorts of bells and whistles isn’t necessarily a big step up.
Here’s a cheat sheet of how to cash in on keeping your financial life simple.
Investing
TDFs. The average target date fund (TDF) typically owns four to six different asset classes, in a mix tied to the investor’s anticipated retirement age.
Moreover, the TDF automatically rebalances from time to time to get back to the “target” allocations for a given asset. And as you age, that target allocation shifts to become slightly more conservative as retirement nears.
Nearly all 401(k)s offer
TDFs, and many “default” new employees into one if they don’t choose other funds. It’s a smart way to get plenty of “sophisticated” elements — diversification, rebalancing, an age-appropriate reduction in portfolio risk as you near retirement — in a simple one-and-done fund.
Indexing. If a TDF isn’t your cup of tea, the next best approach is to focus on low-cost index funds or exchange traded funds (ETFs). Aiming to match a benchmark is undeniably the smartest way to invest. Gobs of data, over gobs of time periods, prove that active managers don’t produce better returns.
Savings
Automate. Set up an automatic transfer from your checking account to a separate savings account that transfers money every week, two weeks or month. Don’t talk yourself out of this before you give it a try. What typically happens is that once people go this route they find they can live with the transfers, and if necessary can adjust their spending.
Life insurance
Term over permanent. There are two main types of life insurance: term and permanent policies. Term life insurance is the “simple” approach, in place for a set number of years (the term), and unlike permanent it does not have an investment component. For the vast majority of life insurance needs, term insurance is simple and smart. It costs a fraction of permanent insurance. And you are typically better off doing your investing elsewhere.
Income annuities over everything else. As retirement nears, a smart strategy is to create a plan for all your fixed essential costs to be covered by guaranteed income, such as Social Security and a pension payment. But if those guaranteed income sources won’t cover your basic expenses, buying an annuity can make up the gap.
Here, too, simple works great. Check out income annuities. They are a plain vanilla type of annuity where you fork over a chunk of money and then, based on your age and when the payments start, you are guaranteed payments for the rest of your life. No bells and whistles.