The Investing Pyramid

If you were born in the 80s or earlier, you are probably very familiar with the USDA food pyramid, which was supposed to guide us all on how to eat in a nutritionally sound way for maximum health. Well, in that same vane, we can now see an Investment Pyramid (notably, NOT put out by the USDA) that can provide some structure around how to invest in a sound way and maximize your wealth over time.

Meb Faber put together this pyramid, and I think it's quite useful:

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Don't Do Dumb Things

At the very bottom, we have the all-encompassing, "Don't do dumb things". At the most basic level, don't blow up your own portfolio. If you are planning to invest for the long term, your portfolio needs to survive! Avoiding self-inflicted wounds (and dumb mistakes) is a good starting point. What do we mean by that? Carl Richards writes a lot about the "Behavior Gap", which can be seen in the difference between how a mutual fund performs vs how the investors who actually own the fund do in that fund. The surprising (or maybe not surprising) truth is that mutual fund owners tend to experience far lower returns than the funds they own. Why? Because it's human nature to buy a fund once it's had a streak of great performance (buying high) and sell when a fund starts to perform badly (sell low). That's the exact opposite of what you should be doing (you should buy low and sell high). It's just that it's human nature to chase performance and always want to buy the investments that most recently performed well. Those are often the very funds that are ready to revert to the mean by going through a period of under-performance compared to their peers and benchmark.

Outside of mutual funds, investors also tend to chase the latest hot stock, double down when an investment they own falls (always assuming it's about to go back up) or just plain getting swept up in greed and fear. How to avoid doing dumb things? Just being aware of common investor mistakes is a good starting point. You can read my prior blog post going through all the behavioral errors that investors are prone to make.

Diversify Globally

Don't put all your eggs in one basket. We've all heard that phrase and it makes sense. It seems pretty straightforward to say you should diversify globally. Put your eggs in LOTS of baskets — in lots of companies, in lots of industries, in lots of countries. But the vast majority of investors have a strong home country bias. In the US, investors tend to be US-heavy in their allocation. Japanese investors tend to be Japanese-heavy in their allocation. It happens everywhere, as people confuse familiarity with knowledge. They think since they know more about their home market, it's less risky for them.

This is a problem because it exposes your portfolio to unnecessary risks. Look no further than the Japanese stock market that went nowhere for decades. If you like podcasts and want to learn more about home bias risk, here’s a great (short) episode from the Curious Investor.

Diversifying globally isn't going to completely insulate you from big market risks. In fact, over short-term periods, globally diversified portfolios aren't much better than concentrated portfolios. In 2008-2009 (the Global Financial Crisis) everything fell together. So you probably won't be saved from short-term crashes. It's the longer market slumps and crashes where global diversification really pays off. And it's the longer market slumps and crashes that will cause the most damage if your investments aren’t well-diversified. Over 10 year periods, a single country's market can severely under-perform (again, think Japan). If you hold a single country, you are exposed to that risk. If you hold lots of companies in lots of countries, you'll spread out that risk. Global diversification works, eventually.


Rebalance Regularly, Following a Written, Rules-Based Plan

When the markets drop (and they always do eventually), it's human nature to panic. The opposite is also true. Let's say you started 10 years ago with a portfolio that was 60% stocks and 40% bonds. The markets have gone up quite a bit since then, and if you never rebalanced along the way, you very well may now hold 80% stocks and 20% bonds as the stocks way outperformed the bonds in your portfolio. You might not want to rebalance because you don't want to sell those stocks that have performed so well. But if your plan calls for a 60%/40%, and now you're a 80%/20%, you are suddenly in a much riskier allocation than where you started. If the markets take a tumble, your 80% stock portfolio is almost certainly going to experience quite a downturn. If you had rebalanced back to 60%/40%, you would have been better position for a fall and your overall portfolio would likely have held up much better.

Investment portfolios aren’t entirely “set it and forget it”. They don’t need constant tending, but they do require a bit of maintenance from time to time, especially for rebalancing. Along those same lines, it’s important to have a written plan in place. Any time we insert human judgment into the process, we tend to screw it up with rationalization and wishful thinking. Having a solid, written, rules-based plan means you aren't going to screw it up. You are going to automatically rebalance when needed, effectively selling your winners (locking in gains) and buying the part of your portfolio that is suddenly cheaper. It's a way of forcing you to buy low and sell high.


Pay Attention to Fees

There was a time when broker commissions were ridiculous, trading fees were crazy and fund fees were almost always above 1%. Thankfully, times have changed! Most platforms charge less than $10 for trades, you shouldn't be paying commissions at all, and fund fees should be under 0.3% (and Fidelity even offers a fund with no fund fee at all). Pay attention to the things you can control, and fund fees are definitely one of those things.

The same goes for the fees you pay to an advisor (and yes, I am one of them). If your advisor is charging you a fee to only manage your assets, without offering any value-added services in all the other planning areas (tax planning, retirement planning, insurance planning, college planning, estate planning, cash flow and budgeting, etc.), than you may not be getting the most value for what you are paying.


Implement tax aware investing

No one wants to pay more taxes than they have to. But many investors don’t understand how specific investments are taxed, and as a result, their investments are not as tax efficient as they could be. It could be as simple as keeping portfolio turnover low in taxable accounts and being mindful about what kind of account holds which investments. If you are in a high income tax bracket, you probably don’t want to hold a lot of high dividend yielding funds in that account as you’ll pay taxes on those dividends every year. You’ve got three basic types of accounts to think about from a tax standpoint:

  1. Taxable (regular brokerage accounts)

  2. Tax Deferred (IRAs, 401ks, 403bs, etc)

  3. Tax Free (Roth IRAs, Roth 401ks, etc.)

For each, you’ll want to be sure you are being smart about your asset placement to maximize returns and minimize taxes.

Tilt away from market cap weights

Finally, once you’ve got the basics in place, you might want to think about tilting toward factors. For most investors, low-cost index funds are a good choice. The problem with index funds is that they are all based on market cap weighting. That means the largest companies have a much bigger impact than the smaller companies. That works fine most of the time, but why invest purely due to size? There are investment factors (such as value, size and quality) that you can weight more heavily, and have been shown to produce better returns in the long run, as least historically. For many investors, it makes sense to incorporate some of these factors into their portfolios.

It might not be quite as easy to visualize as the good old food pyramid, but the investor’s pyramid is a great tool and a good starting point for thinking about your own investment portfolio. Start with the basics (don’t do dumb things!) and work your way up. Want to learn more? Feel free to reach out to me and set up a free 30-minute call.

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Alyssa Lum, and all rights are reserved. Read the full Disclaimer.