Updated on 09.05.14

Rule #2: Don’t Over-Think Your Investments.

Trent Hamm

14 money rulesA reader asked me if I could break down my ideas into a handful of principles. After some careful thought, I came up with a list of fourteen basic “rules” that summarize my money and life philosophy. I’ll be presenting these as a weekly series.

I picked up a copy of Money recently and counted the number of mutual fund ads in the issue. My count? 18.

Each one claimed to offer some sort of security for you. Each one claimed to offer superior service and/or superior results.

Then I turned to the content. I saw a huge list of mutual funds, all of which seemed to be described as spectacular. I saw multiple articles discussing how to make saving for retirement or saving for college as complicated and scary as possible.

By the time I sat the issue down, I was almost overwhelmed. With that many investment options and choices out there, how can I possibly ever pick the right one?

The truth? Don’t worry about it.

You’re twenty five. You want to retire at age sixty, so you’ve got thirty five years to go. You decide that $750,000 is a good target. So you start looking into investments.

You do a week’s worth of research, pick an investment that seems pretty good and stable over the long haul, and you decide to dive in and start saving right then and there.

You start socking away $5,000 a year, and that investment only has to earn 7% a year to get you to your goal. You don’t have to have sleepless nights worrying about your investment – 7% is a pretty reasonable goal.

Now, let’s say you look at them – and you’re overwhelmed. You decide to wait a year – and that year becomes five.

You start socking away $5,000 a year now, but the outlook is decidedly worse. You now have to earn 9% a year in order to make that $750,000 goal. Instead of being able to sock that money away and not worry about it, you’ll now have to micromanage it – and even then, you likely still won’t make it.

What’s the moral of the story? You’re better off starting your savings now rather than waiting until you find the “perfect” investment. The perfect is always the enemy of the good. Sure, you can keep your eye out for a better investment, but you don’t have to have world-beating Peter Lynch-like returns in order to make your goals.

So what’s a “good” investment? For starters, an index fund: they’re easy and don’t require much time investment, they’re very cost efficient, and they outperform virtually all managed mutual funds. Burton J. Malkiel, in his seminal The Random Walk Guide to Investing, makes a brilliant case for them:

[Index fund investing] has outperformed all but a tiny handful of the thousands of equity mutual funds that are sold to the public. Let’s list all the advantages of an index fund strategy:
– Index funds simplify investing. You don’t have to choose among the thousands of individual stocks and mutual funds available to the public.
– Index funds are cost-efficient. [Many] have no sales charges and have miniscule expense charges. Moreover, index funds do a minimal amount of trading. Thus, they avoid the very heavy transactions costs of actively managed funds, which tend to turn over their entire portfolio about once a year.
Index funds regularly produce higher returns for investors than do actively managed funds.
– Index funds are predictable. You know beyond doubt that you will earn the rate of return provided by the stock market. Yes, you will lose money when the market declines, but you will never own the fund that performs several times worse than the market.
– Index funds are tax-efficient. If you do own stocks in taxable accounts (that is, outside your IRA or retirement plan), then you need to invest in index funds that don’t trade from security to security and therefor don’t tend to generate taxable gains.

Another great summary can be found in the excellent article The Best Investment Advice You’ll Never Get at San Francisco Online.

Addressing Your Investment Concerns

Stock Market Downturns

Obviously, putting all your money into a stock index fund puts you completely at the whim of the stock market – and as many people discovered in 2008, that’s not a good thing at all.

Whenever I think of the downturn of 2008, I think of my mother- and father-in-law. Their retirement plans hit such a serious roadblock that they went from hinting vaguely at retirement (and the requisite travel and spending time with grandchildren that would come with it) to joking about working until they fall down dead on the job.

How do you protect yourself against that, huh? The trick is diversification, especially as you get closer to retirement. When you’re a long way out – thirty years or more from retirement – it doesn’t hurt to bet quite a bit on the big return – but with that big bet comes big risk. If you have everything in stocks and the stocks drop, then everything you have saved drops.

So, as retirement gets closer, you’re well-served to gradually move things out of stocks and into bonds, real estate, cash, or other investments. You’re no longer trying to hit home runs – you’re happy just to not strike out when your retirement comes close. So diversify.

Again, many investments make that easy. Most plans offer some version of a “target retirement” plan that will do just that for you. As you approach your retirement age, the plan will gradually – automatically – shift money from a heavy stock investment (great when you’re young and can afford to swing for the fences and risk a strikeout or two) to a very diverse investment (best when you’re older and you can’t afford to strike out).

That’s all there is to it. Start saving now, preferably in a target retirement plan made up of index funds. You can watch for better investments if you want to, but the sheer advantage of saving now in a low-cost plan that automatically diversifies for you as you get older will be hard to beat.

Roth IRA vs. 401(k)

Here’s the truth: they’re both pretty good. In either one, you’re not hit with tax penalties for diversifying your retirement savings. Given that we don’t know what the tax rates will be in thirty years, it’s impossible to say which one is better, and people will argue until they’re blue in the face without being able to come up with a real answer.

A general good rule of thumb is to contribute to your 401(k) up to the maximum amount that your employee matches (because employee matching is basically free money). If you want to save more, start a Roth IRA (because you have more investing choices).

However, the importance of actually saving blows away the differences between the two. You’re light years better off simply throwing everything you can into savings than sweating about which investment option is the best. Again, the perfect is the enemy of the good.

College Savings Accounts

Virtually the same exact principles apply to college savings as apply to retirement savings. Saving now is the most important thing, and diversifying as you get close to the big day is vital, too. Just pick a good 529 savings account – preferably one like Iowa’s that has a “target graduation” investment option – and start socking away the money now.

That’s really all you need to know about investing, for all practical purposes. The earlier you invest, the better. If you can, use a plan that enables you to invest with tax protections (Roth IRAs, 401(k)s, 529s). The farther away you are from the event you’re saving for, the more heavily you should invest in stocks (high risk, high reward). The closer you get to your big event, the more you should diversify (lower risk, lower reward).

I use Vanguard for pretty much all of my investments – they make all of this so easy that once you’ve set it up, you barely have to think about it again. I know that if the stock market dips again, I don’t have to panic – my short-term stuff is safely out of stocks and my long-term stuff has plenty of time to recover. I know I’m investing now rather than later, giving compound interest plenty of time to work in my favor.

It all just works – and for all of the complexity that publications like Money try to throw into the mix, that simplicity is what we all strive for.

Remember: don’t overthink things. The perfect is the enemy of the good, and if you get obsessed with the perfect, you’ll lose the good along the way.

Loading Disqus Comments ...
Loading Facebook Comments ...
  1. Michael says:

    1. $750k to retire at 65? Try a couple million…
    2. Diversification would’ve protected your money lately? Do you allocate money to puts and credit default swaps?

    Good article otherwise. It’s so important to start saving immediately.

  2. LVz says:

    I was once told by a CFP that after funding our 401k we should fully fund our Roth IRA’s and use the contribution portion to pay for our son’s college. Has anyone heard of this strategy?

  3. Ryan says:

    My thoughts exactly. Though I’m guessing Trent just picked a figure for illustrative purposes. But yes, 750k isn’t much, but it also depends on the savers income/lifestyle.

    I’m 25 at the moment, and I’d love to have 750k in my accounts. :)

  4. MLR says:

    @ Michael (#1)

    Agreed, $750,000 seems a little low. But the point remains the same (just that $5,000 either needs to go up, or the return does… and I think its safer to assume the amount invested should be the first to go up!).

  5. Joe Light says:

    I guess I agree with the first commenter. A rule of thumb is that you can withdraw 4% of your nest egg in your first year of retirement. Four percent of $750,000 is $30,000. Assuming that inflation stays at its 3% historical rate (which might be conservative), $30,000 will feel more like $12,000 30 years from now. Assume that Social Security is even around, and you’re still living pretty poorly.

    Saving early is definitely something people should do. But I feel like personal finance has overrated “compound interest” for a long time to make it seem like if you start early you don’t have to save very much. If you save like that and then there’s a crash near when you want to retire, you’ll be nowhere near where you need to be. Vanguard’s 2010 Target-Date retirement fund lost 20% last year…

  6. a conscience life says:

    @ Joe Light
    In your example, what if the rate of return on your &750,000 was 7% in retirement? Then you would be able to cover the inflation as well (should you believe in inflation) and you could live comfortably in retirement indefinitely.

    Of course this assumes that your rate does not drop much below 7% for any length of time — which is a problem with almost ALL retirement advice. It turns out that when you retire the STABILITY of your return is *much* more important than the SIZE of your return. I for one would much rather have a guaranteed rate of 5% than an average of 7% that fluctuates between 3% and 10%. Note: This only applies in retirement situations and when you are getting close to retirement.

    This is, of course, why people speak of “diversification,” though I feel this term is actually misused. What you are trying to do, as you approach retirement is not to diversify, but to reduce the amount of variation in your returns. For instance, if you had enough money, then the best retirement investment would be in 30 year government bonds. So, the term “diversification” is misleading (since you would LIKE to have everything in bonds, in reality). Rather, perhaps “reducing volatility” is a better descriptor.

  7. AnnJo says:

    I can’t help wondering what would happen if most individual investors opted for index funds, as so many are now suggesting.

    “The market” historically has represented the best financial wisdom, such as it was, of the entire investor class. Managed mutual funds ended up with a large stake, narrowing the base from which this “wisdom” is coming, and with index funds, the base will be narrowed even more.

    Buying an index fund is the same as delegating your thinking to whomever else is still doing any thinking. Everyone who does that is withholding his or her own little bit of special perspective or knowledge, making the market less a reflection of the collective wisdom of all investors, and more a reflction of the collective wisdom of large institutional fund managers. That’s bound to change the market as a whole, and therefore is likely to mean that future returns will less closely track historical returns – either for better or for worse.

    Please understand I’m not saying there’s anything wrong with choosing index funds, only that as more people do that, “the market” will be a different creature than it was before, and presumably so will its overall rate of return.

    $750,000 (in today’s dollars, i.e., inflation-adjusted) of retirement savings at age 60 is far above the current average retirement savings and not an unreasonable goal. Especially combined with a paid-off house and modest spending habits, one could live comfortably on that in all but a few parts of the country.

    However, to get to the equivalent of $750,000 in today’s dollars on $5,000 a year savings over 35 years requires monthly compounding based on an annual rate of return of 7% OVER INFLATION, not just an “average” rate of return of 7% per annum. A 35-year compounding rate of return of 7% per annum over inflation is not very likely.

    If you haven’t already done one, a column on the difference between “average annual rate of return” and “compounded annual rate of return” and the effects of that difference on a portfolio would be very informative for your readers.

    The only “risk-free” inflation-adjusted investments out there are the inflation-protected Treasuries (TIPS), which I think on current issues are yielding less than 2%. Any return above that represents an extra premium you are being paid for the risk that you will lose some or all of your principal. And losses to your principal can dramatically lower your COMPOUNDED rate of return, even if your AVERAGE return recovers.

    So, although for different reasons, I would urge a 25-year old to try to do better than $5,000 a year, if at all possible. But any amount at all is better than nothing.

  8. Trent,


    No disrespect intended, but you are trotting out the old ‘rules of thumb.’ Those are simply not good enough. Just look at the people you know to see that’s the truth. Fresh ideas are needed.

    The people who take responsibility for managing money – are out to protect themselves from lawsuits. They are not out to give you winning advice. That’s why they advise diversification, asset allocation, buy stocks in bull and bear markets etc. With those ‘prudent’ suggestions, they cannot be sued successfully.

    That’s the truth as to why those are the ‘rules,’ But if you think for yourself – as you seem to be doing in all areas of PF, then you will discover that the old-fashioned, incorrect, unhelpful advice that everyone offers, is not good advice after all. It’s just a cover-up so the ‘professionals’ can take your money with fees and commissions and protect themselves from any responsibility.

    Diversification does not work. it’s a myth. What it does do – is it helps most of the time. But it would not ave helped last year. And most is not good enough.

    What works is a cheap insurance policy. And that’s where conservative option strategies come into play. Specifically collars, but there are other choices.


  9. Joe Light says:

    @a conscious life

    Thanks for the clarification. The point I was trying to make was that $30,000 per year (which is like $12,000 in today’s dollars) plus whatever Social Security you get is not very much to live on. If you only had to withdraw $30k off of $750k then you wouldn’t run out of money–your standard of living would just be really low.

  10. Michael says:

    AnnJo, index funds only work to the extent active traders efficiently act on available information. If most of the money’s in index funds, volume would drop and prices would move more erratically. It’s possible this could disrupt the ability of index managers to choose the right stocks, but that obviously hasn’t been tested yet.

    Anyway, as poor investors like Trent and J.D. Roth move their money into indexes and encourage other poor investors to do the same, the average skill in the market will rise and active investing will become more difficult. The new group of poor investors might leave for index funds as well, creating an interesting cycle that makes active investing very difficult.

    On the other hand, indexes are predictable and it’s easy to make money trading shares before the prospectuses of index funds force them to trade. This especially happens when a company becomes large enough to join the S&P 500. Someday half the money in the market might be in indexes, and if they have to add or sell a security, trade in that security will be so imbalanced (as not enough active traders exist to take the opposite bet) that returns will greatly suffer.

  11. Joe Light says:

    @a conscience life

    Thanks for the clarification. The point I was trying to make was that $30,000 per year (which is like $12,000 in today’s dollars) plus whatever Social Security you get is not very much to live on. If you only had to withdraw $30k off of $750k then you wouldn’t run out of money–your standard of living would just be really low.

  12. Craig says:

    I dont have a problem really with index funds, but I feel like it is always accepting the average. You are accepting the the overall market returns are as good as you can do. However, there are LOTS of funds out there that consistently beat the market year after year with very competitve expense ratios. With a little research, these funds are not hard to find. Just relying on index funds and/or “target” funds seems to be the lazy mans approach to me.

  13. kat says:

    I have always run into a different sort of problem. there are companies that I will not do business with because of my ethical beliefs. I don’t want to invest in them either. I was not always given that option through a company 401K. Thre were several funds marketed as “green or ethical” but did not get much of a return. Does anyone else have thoughts about this? Trent, maybe this could be a subject for you?

  14. Marsha says:

    Where can I earn 9% (or 7% over inflation) per year on my investments? :P

  15. George says:

    As Michael said in the first post, diversification would NOT have saved you in 2008. You could have minimized the effects by holding cash or trading esoteric securities, but unless you moved all of your funds into those (which isn’t diversification), then you still would have taken a hit.

    Everything else (bond funds, REITs, stocks, foreign currency, oil, gold, etc.) got clobbered in 2008 as highly leveraged concerns had to sell their assets to raise cash in order to pay their bills.

  16. Katie says:

    @AnnJo – The institutions that really move the market do not rely on index funds to the same extent small investors do. Hedge funds, mutual funds, and other institutional buyers move their money around and purchase/sell large numbers of shares at a time, causing changes in the underlying price. Even if everyone reading this went and put a bit of money in index funds (many of which are now passively managed by…a computer), larger companies and investors would still be the major reason prices moved.

  17. ChrisB says:

    Craig, John Bogle’s books have convinced me that by aiming for just average, an index fund investor’s holdings will end up performing *better* than average. In a couple of his books his taken all of the mutual funds of the 20-30 years (as of his writing)… only a small handful of actively managed funds out of thousands beat the market over that time period, and he notes that the likelihood of the average investor correctly picking those funds is rather low.

    And as they always say, past performance is no guarantee of future results… say an investor researches funds with a good 5-10 year track record and goes with one of them; what happens if the manager who led that fund retires in two years? I used Magellan to help pay for college back when Peter Lynch was the manager, and I’m glad he hadn’t retired sooner! (Magellan today isn’t nearly the fund it was under Lynch.)

    I’ll shoot for average and happily take the above average results.

  18. Sean says:

    Is it just me…or did everyone miss the point Trent was trying to make?

    How did we go from the premise “Don’t Over Think Your Investments” to a rant about whether $750k is enough or what impact inflation will have or whether social security will be around or how much someone needs to live on?

    I think Trent makes a sound argument and comments like these further this belief. None of us know what tomorrow will bring, neither do the experts nor the clowns on wall street that tell us they do.

    Far too many people get wrapped up, and subsequently confused, by the messages sent by the financial industry (all with the aim of selling a product and taking your money) and it really does not need to be that way. Keep it simple is a great strategy.

  19. getagrip says:

    It seems to me that sometimes the problem is that people look at what they’re “supposed” to be saving/investing and realize that there is no way they can currently afford the amounts or percentages of salary, so they just throw their hands in the air and either give up or figure they’ll deal with it (e.g. retirement, college, etc.) when the time comes. Comments like “$750k to retire at 65? Try a couple million” or “$30,000 per year…is not very much to live on.” while technically true can be pretty demoralizing when you can’t even see how you’ll be able to save half a million.

    My take is $750K (inflation eaten or not) is better than nothing, and $30K a year is better than $10K, and goals can grow or change as your own circumstances do. You don’t have to save at the max now. Save what you can and work to build it. I started with 5% of my salary for retirement, then inched it up over the years to 15% now. Will it be enough? I don’t know, but it’ll be a hell of a lot better than if I didn’t save anything or waited until I thought I could start with the 15%. I also realized there was no way I was going to fully fund my children’s college (and a mortgage, and car payments, and retirement) but I wanted to save something. So when each was born I started with $20 a paycheck and added $5 every raise or COL increase. My oldest starts state college in the fall and she’ll be taking out loans. But we are better off for what I managed to save, even it only pays for about half.

    The main point of the above article is to start saving and don’t fall into paralysis of analysis in looking at all the options. My point to add is save something, anything, and try to regularly grow that amount over the years as you can because all the estimates, projections and advise mean squat if you don’t have something to work with in the end.

  20. ken swift says:

    The discussion about diversification, in my opinion and experience, is usually related strictly to Stock Market investments.

    How about Total NET WORTH diversification which includes debt, assets outside of the Stock Markets along with 100% safe Cash, real estate etc. When ALL of your assets are considered and liabilities deducted from Debt you have a complete picture of where you are and you MAY see you are totally reliant on one of several classes of assets or Stock Market investments.

    If your Net Worth isn’t growing and you have $$$ in the Stock Market its a belief that you are doing the right things? Wrong! My point is that all of the debt reduction schemes one can come up with is only one small part of total diversification. The word itself can mean a much wider scope than simply Stocks, Bonds, Cash.

    You will NOT find this Net Worth approach in most Mutual fund or investment guidance because they want ALL of your money.

    Example is Madoff investors who sold all assets and put all money in his investments and lived off the income! Totally naive people and you gotta WORK at this stuff to assure that no single sector or asset class is succeptable to a major loss or downturn.

    Also, downside limited investments with 50-60+% of an upside market could leave one with 20-30% losses versus 50-60% losses. Calculate the “get back to even” on these and you can see that limiting losses is an important strategy. 5yr recovery versus 10+ years is important for people to know about.

    There is much more involved with this approach but you will NOT see most investment companies or mutual fund companies using a total net worth approach.

    No matter what you pick for a retirement #’s it makes little difference if you arrive there and have what has just happened 20 years from today!

    That thought is way too narrowly discussed and simply starting saving early is not the answer. Start early and recognize you MUST be totally diversified through out your life. Debt is one HUGE influence on your success for sure but ending with everything in the Stock Markets only puts your money where somone else profits daily, weekly monthly with continual fee erosion, even when you are losing money. Even inflation erosion on cash in 2008 was about 40% less loss than being in the Market.

    I was -34% in the market in 2008, -30% housing equity and with cash building for the last 9 years end up with a total Net Worth related loss of -18%. Market recovery is 5.4 years at 7.5% returns versus 10.3 years for others. Housing recovery is not even predictable……… Stock Market assets are only 26% of total net worth.

    Zero debt.

    66yrs old, still can retire tomorrow morning if I want to. Could NOT have achieved this without the net worth approach. 10+ Years ago did an ongoing analysis and found 50%+ of net worth was in my HOME. Rest was in Markets at that time. Huge appreciation of real estate skewed the numbers.

    Calculated that I had enough “deferred investments” that I will pay taxes on in retirement This is another aspect for the 20 somethings to be told about! You can have too much in deferred 401K and IRAs at some point.

    No one is gonna tell you this from Mutual fund company…………..

    Ken Swift

  21. Mike says:

    This is response to # 2. Yes if you fund your Roth IRA then you can withdraw what you put in, without any tax implications. You cannot take any of the interest earned however, if you do that then there’s a penalty.

    Good choice if you don’t know if you son/daughter are going to go to college.

  22. Curtis says:

    To all who are saying that diversification doesn’t work…

    Diversification is not a fail safe plan. There is no such thing. With the possibility of return comes risk. So no matter how you invest you are going to come up against some risk, yes even govt bonds, even though they are said to have no risk, technically they do have some risk.
    Diversification does work the way it is designed to work. Even though I believe there is such a thing as over-diversification, diversification itself is a good idea for the average investor.
    I have read a few articles that speak about the 2008 collapse and how financial advisers need to come up with a different strategy because diversification doesn’t work. This is just simply not true.
    There are two types of risk out there, idiosyncratic risk and systematic risk. Idiosyncratic risk is risk that affects only a certain area of the market. Systematic risk affects the whole entire market. The collapse in 2008 is considered Systematic risk and diversification by definition is designed only to protect against idiosyncratic risk (which is why it’s also called diversifiable risk). For example if I diversified by buying 1000 shares of GM stock and BOA before the collapse I would have nothing left of the 1000 I had in GM stock. However I would still have my 1000 in BOA. You’re saying that BOA is worth a lot less than it was 2 years ago. Well this is true because the systematic risk brought the whole market down. However if I didn’t diversify and bought a 1000 in GM and 1000 in Chrysler (both in the auto market) I would have nothing. So diversification works but it will not protect you against a total economy collapse.
    Saying that diversification failed in 2008 would be like building a sand bag wall around your house and then complaining because it didn’t stop water from leaking through your foundation. It’s just simply not meant to protect against that.

  23. I agree that diversification and the use of low cost funds (e.g. index funds) is a sound way to invest. One of the most important aspects of diversification is to pick the asset classes. Markets are pretty efficient within an asset class but not so much across asset classes. Find the right blend of assets – and start by picking the asset classes. We like emerging markets right now. So we have several emerging market mutual funds. What happens within and between those funds matters less than how emerging markets are doing generally and how they compare to other asset classes such as government bonds, international small cap, large cap stocks, etc.

  24. Shaun says:

    Pretty much aggree. The media seem to overcomplicate investing. I do pretty well in the market and I avoid a lot of the news.

    Investing doesn’t need to be complicated.

  25. Jason Baudendistel says:

    What if you pick your own stocks? Wouldnt that increase your returns if your analyses is correct?

  26. Steve in W MA says:

    $750K in 2010 dollars is reasonable and is more than most will ever accumulate. It’s probably about 2 million in 2040 dollars.

    I disagree that index fund investing is the most efficient for this. How about just accumulating your annual investment amount every year and dropping the whole load on one stock that’s in the DOW or the S&P 500? Do this either once or twice a year. Mark on the calendar what your investment month is. Talk about tax efficient and low-cost in terms of loads. one $10 brokerage fee on $5,000 equates to 2/10 of a percentage point. That’s your total investment cost for the year, 2/10 of one percent. Now hold the stock for say 10 years. For 9 of those years you’ll pay NO investment cost or management fee.

    Every year, buy a different stock, in a different sector. Within 10 years you’ll be fairly diversified. Within 20 years you’ll be very diversified.

    You will, of course, at times want to rebalance your portfolio, but that’s another topic. My point is that if you have a long term horizon, buying stock directly is the most efficient and low cost method, at the initial disadvantage of low diversification. But within about 10 years you’ll be as diversified as you really need to be.

  27. Nick Thacker says:

    Another great post; still–a little too general.

    I really love the style you put into every post, Trent, but I think the topic of investing needs more than “index funds; diversify.”

    My two cents: do index funds and diversification work? Absolutely.

    Are there other investments/investment strategies that work better? Absolutely.

    Should you use them? Maybe.

    I’m hoping to cover the topic of investing while still young over at my new blog (www.younginvesting.com), because I’ve always felt that personal finance authors and bloggers fall desperately short in explaining thoroughly the strategies for investing.

    Without a sound investment strategy, all we are are frugal penny-pinchers at worst, and happy “just-getting-by”ers at best.

    Not to rain on anyone’s parade, I just think I have a bone to pick with the whole “personal finance” industry (as well as the public education system!) for not helping to educate us how, when, and why to invest after we’ve learned to save more and spend less.

  28. Anuj Joshi says:

    Buying an index fund is fine that will itself take care of diversification.As index is composed of companies from different industries.

    One needs to time the purchase of fund buying as well.It is believed that no one can time the investment perfectly.Still one need to invest systematically over time and at different price levels. Preferably when markets are trading at historically undervalued price levels and opposite in case of selling.

Leave a Reply

Your email address will not be published. Required fields are marked *