There are endless investment strategies available, making the investing game for beginners a stressful journey. Rapping your head around how the stock market works in and of itself can be mind-boggling. So, how is a beginning investor to choose the right investment strategy? With some timeless principles and proven methods, the answer to this question is actually much more simple than you think.
What is the best investment strategy for beginners? One that's easy to understand, simple to manage, and one that protects against too much risk. Here's how it works…
New to investing in the stock market? Take a look at our guide – Investing For Beginners
Investing Strategies For New Investors
To give you some options, we'll show you 3 investing strategies for new investors that meet the three criteria above; they are easy to understand, simple to manage and protect against too much risk. The three beginner investment strategies we'll discuss are:
- The Three Fund Portfolio
- Index Fund Investing
- The Defensive Investor's Portfolio
All three strategies are well diversified strategies that have tested the times in both good and bad economic markets.
The Three Fund Portfolio
You may be familiar with Vanguard, arguably one of the top investment companies available today. Jack Bogle, the founder, is known for promoting the three fund portfolio due to it's simplicity, diversification and hedge against risk.
The Three Fund Portfolio consists of…you guessed it…three different funds. Each fund tracks an overall market index making it a very diversified investment strategy. The three index funds included in a three fund portfolio strategy are:
- Total US Stock Market Fund
- Total US Bond Market Fund
- International Stock Fund
Each of these funds are comprised of the majority of the companies found within its given market. For the Total US Stock Market Fund, this is a fund that has 3,000+ companies found in the US Stock Market, and whose overall performance make up the overall performance of the US Stock Market. The same is true for the Total US Bond Market Fund, and the International Stock Fund. Each consists of perhaps thousands of companies that make up it's respective market sector.
The Three Fund Portfolio: How To Allocate Your Funds
The great thing about the three fund portfolio is that you can choose just how much of your portfolio is allocated to each fund, while still maintaining a very diversified portfolio.
Depending on your risk tolerance, you may wish to include most of your money in stocks vs. bonds, or vice versa. You'll want to decide how much you want allocated between stocks and bonds, and then further decide how much you want invested between US Stocks and International Stocks. International stocks are riskier by nature. An example might be:
The above example would be a more aggressive portfolio, most likely for someone who expects to keep their funds invested for at least 10-15 years. The portfolio is comprised of 50% invested in the Total US Stock Market, 30% in International Stock Funds, and 20% in the Total US Bond Market. Broken down, it is as follows:
Total Stocks: 80%
- Total US Stock Market: 50%
- International Stock: 30%
Total Bonds: 20%
- Total US Bond Market: 20%
Which funds should you use with the 3 fund portfolio? You can choose to use mutual funds that track the above markets, or exchange traded funds (ETF's). The main difference between the two are how the funds are managed, and the structured investment fees. To make things even easier, I recommend sticking with ETF funds since they are more cost effective most of the time, and are by nature a more simple investment vehicle.
Why invest using the 3 fund portfolio strategy? As you can see, it's very well diversified, it allows for customization between the funds, it's low cost, and you're investing in nearly every stock, bond and international stock available. With this investment strategy, you will do better than most expert investors.
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Index Fund Investing
Index Fund Investing is a simple investment strategy that consists of allocating your assets among a handful of different index funds that track specific markets and market sectors. In effect, the 3 fund portfolio is a form of index fund investing since the investments track different markets.
The question you need to answer, is how to allocate your funds and among which markets and market sectors do you wish to invest in. Here's how to go about this decision.
Index Fund Investing: How To Allocate Your Funds
To start, ask yourself how much of your money you want allocated to stocks and how much you want allocated to bonds. Your answer can be as extreme as 100% in stocks and 0% in bonds, and as conservative as 0% in stocks and 100% in bonds. One is very aggressive and the other is very conservative, and anything in between is a mix that you may feel fits your risk tolerance best. Personally, I tend to keep my funds invested more aggressively, and thus I choose to have 90% in stocks and 10% in bonds.
Next, we need to decide how to allocate the investments among both stocks and bonds, using different index funds available.
How should you choose which stock indices to invest in? This approach is completely personal, and depends on your core beliefs and objectives. Perhaps you're a strong advocate for the technology sector, blue chip stocks, and small cap stocks with potential to grow. If this were the case, you may choose to invest in the following index funds:
- US Technology Index Funds
- Blue Chip Index Funds
- Small Cap Index Funds
How should you choose which bond indices to invest in? With the same approach as deciding which indices to use for stocks, we will choose which indices we want to include in the bond portion of our portfolio. Since the bond portion of our portfolio is by nature an included investment to limit risk, we will choose to invest the whole bond portion into US Corporate bonds.
After picking the indices you want to invest in, your overall investment portfolio might look something like this:
Total invested in stock: 90%
- US Technology Index Funds: 20%
- Blue Chip Index Funds: 55%
- Small Cap Index Funds: 15%
Total invested in bonds: 10%
- US Corporate Bond Index Fund: 10%
As in the 3 fund portfolio, I recommend using ETF's for ease and low cost investments.
The Defensive Investor's Portfolio
The Defensive Investor's portfolio is a basic investment strategy as taught by Benjamin Graham in his timeless book “The Intelligent Investor.” In it, Graham seeks to explain that achieving a fairly moderate return for a long period of time is much more effective than seeking above the norm returns, and over the long term, ends up winning almost every time.
This investment strategy follows two basic principles:
- Risk allocation
First, the defensive investor needs to have a diversified portfolio to hedge against loss. When one company may be performing poorly, another may be performing significantly better to offset the potentially negative return, and instead, provide a positive growth.
As shown in previous strategies, this is best done by investing in an index fund that tracks an entire market sector, or the market as a whole. Graham suggests that if you prefer to have a more passive approach to investing, diversify among stocks by investing in an index fund that matches the S&P 500 index, or the Total US Stock Market index.
Secondly, when referring to risk allocation, we're talking about deciding how much of your money is invested in stocks, and how much is invested in bonds. Graham suggests that one should never, in any case, have more than 75% of his or her portfolio in stocks or bonds. This suggests that you choose between an asset allocation of:
- 75% stocks and 25% bonds
- 25% stocks and 75% bonds
- Or anywhere in between
For your bond portfolio, investing in US Corporate Bonds or a fund that matches the overall US Corporate Bond market is suggested.
Put simply, the defensive investor's portfolio simply consists of a mix of stocks and bonds, never more than 75% invested in one and never less than 25% invested in the other, and purchases index funds that match the overall market returns.
To go one further for a more hands on active investor who wishes to spend extra time and due diligence in their portfolio, one may choose to follow the same allocation strategy while picking between 10 and 30 stocks diversified among many companies, market sectors and company sizes. The same goes for the bond portion of your portfolio.
If you're just starting out investing, it's suggested you take the passive approach and use index funds to begin with, and perhaps over time you can transition to a more actively managed portfolio as you wish.