I know that this is a dry topic for most people, but it’s seriously under served.
In high school, I didn’t have any sort of financial education aside from the now-mostly-irrelevant task of balancing a checkbook, highlighting that there’s a difference between when a transaction is authorized and when it posts. I remember some silliness of teachers investing in this company or that company, but I never really understood how to design a portfolio or an investment strategy.
I’m not here to teach you either. Just know that you should have a strategy. You need to:
- Have an emergency fund to enable you to invest by preventing liquidation at a bad time. If you can’t handle a financial emergency, you aren’t ready to invest.
- Understand your time horizon. When do you need the money? How long can you afford to tie it up?
- Understand your risk tolerance (or how much risk you need to take to meet your goals).
For most people, the recommended answer seems to be a low cost, diversified index fund.
Now, I’m going to share what I personally do for my retirement and taxable accounts, taken as a whole. Restating my goals here also helps me stick to the plan and maintain conviction even when the future seems uncertain. None of this is financial advice, and I’m not promoting any product or service. This post is for my reference and your entertainment/education.
Retirement Account: Regret Minimization
The retirement account isn’t a place for me to try bold new strategies. We know what generally works based on the past performance of the markets. Also, because this is investing over a long time period (hopefully), we also want to minimize regret which means sticking close to the overall market performance, which tends to be about 7% real returns annualized. Most of us would like to retire someday, so it’s best that we stick to proven plans.
I adopt a ready-made solution as my core holding: a target date fund (example) that automatically shifts between all-in aggressive stance on equities when I’m younger to a defensive 60% bonds and 40% equities (stocks) as I’m nearing retirement. Within these holdings, a good fund is highly diversified and invests in both global and domestic stocks and bonds. This type of fund is available at many institutions and these days even the most basic retirement plan has a target date fund option. Typically, you select your retirement year, plan your contributions, and that’s all. Don’t worry about market ups and downs. Just stick to the plan of consistently investing, and the target date fund automatically chooses a balance of risk that is best for most people.
I choose to enhance my retirement account with a 20% investment into small cap value stocks (SCV) which is a type of stock that is historically known to be more volatile with long periods of poor performance, but should win out over general stocks over decades. The premise is that smaller companies and companies with a low stock price tend to be riskier investments. By taking on this extra risk, I seek enhanced returns, at the price of increase volatility and diverging a little from the recommended plan that fits most people. With that said, I used a target date fund as my only holding for years, and it did a great job of managing the right amount of risk and staying invested. I’m also sticking to a 20% slice to ensure that even if my performance diverges from the market, I still have 80% invested in generally-accepted best practice.
I keep my retirement account simple, with 80% invested in a target date fund, and 20% invested in small cap value which I will manually reduce to 0% as I age. I’m not trying to beat the market. I’m sticking to methods that are highly likely to perform well over decades.
Taxable Account: Optionality
The taxable account is much more of a wild west. Many people don’t have taxable investment accounts at all. Others actively trade stocks, and other still hold retirement-account-like configurations. I think it’s too difficult and too personal to suggest general principles for taxable account investing. So many factors come into play.
| Factor | My Personal Situation |
| Time Horizon: When do you need the money? | 1-20 years. I want optionality over different time horizons. Some parts might stay in the account for decades, while others could be sold in as little as a year to fund a large purchase. |
| Tax: How defense do you need to be against taxes? Someone with a high income in a state with state taxes cares a lot, but someone in a state-tax-free state like Washington might care less. Municipals are federally tax free while treasuries are state-tax-free. | Income from bonds is usually taxable as ordinary income, so I want to keep the bonds portion as small as I can allow. Some of the bonds should be in municipal bonds that are federally tax free. Most of the investment should be in equities which has a much more favorable capital gains tax rate compared to income. |
Here’s my personal breakdown for my taxable account:
- 70% stocks, 30% bonds.
This tilt towards stocks reduces tax drag because selling stock (capital gains) is highly tax favored compared to bond income without special conditions on the bond. I feel that 30% of bonds is the least amount of bond I can hold while still providing enough optionality during a stock market downturn. - Within the bond sleeve: a 2-to-1 ratio of short term corporate bonds to medium term municipal bonds.
The reasoning is that we care a lot about tax cutting into the already very limited investment returns of bonds. Short term municipal bonds solve the tax problem, but the interest rate is too low because many high-wealth persons buy up those bonds.
To fix this problem, I buy short term corporate bonds for my short term needs (rich people can’t buy these because their tax rate is too high to make it worthwhile) and medium term municipals (not overbought by the same wealthy investors). Shorter term bonds are less risky because they don’t change in value as much when interest rates change, so the 2-to-1 ratio leans towards giving me more ability to spend if I want to spend from my taxable investments. Corporate bonds are quite nice for the individual investor because other investors can’t take the tax hit, and still others like institutions are often mandated to buy US Treasuries, or government debt, instead of business debt.
You should look at the current yields and your tax rate to determine what types of bonds and in what proportions meet your goals. My goal was to buy the fewest bonds with the most optionality, and this combination works best for me for my tax rates. - Within the equity sleeve: 15% SCV, 85% total world stock.
The lion’s share of my equity investment is with total world stock. This provide the ultimate diversification by investing in practically all investable business. Nearly all growth comes from this investment over long periods. Short term sales will come from bonds or from here only if the market is up. Note that the market can perform poorly for years at a time.
The 15% SCV tilt continues my conviction that small cap value stocks provide elevated returns over long periods.
Conclusion
I think that retirement accounts are better understood than taxable accounts because many more people can agree on reasonable retirement account goals. I stick to proven, recommended retirement investment funds. In my taxable account, I use bonds to try to stagger in some optionality to support purchases. This feels like the right balance for my personal situation.
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