Investments: Vanguard's Guide To Choosing Wisely

Choosing the right investments for you is a complex process that depends on your goals and investing style. Vanguard recommends that you start by deciding what you are investing for. This could be for long-term goals, such as retirement, or short-term goals, such as buying a new car. Once you know your goals, you can consider the different types of investments available, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Vanguard also suggests that you take its Investor Questionnaire, which will suggest an asset mix based on your risk tolerance, investing experience, and time horizon.

Understand your investment goals

Understanding your investment goals is a critical step in building a focused financial plan. Here are some key considerations to help you define your investment goals effectively:

Identify Common Types of Financial Goals:

Recognize the different types of financial goals you may have. These can include life events such as a wedding or vacation, retirement planning, funding emergency reserves, starting a family, or saving for college. Understanding the nature of your financial goals is the first step towards achieving them.

Apply the SMART Framework:

The SMART framework is a widely recognized tool for setting effective goals. Ensure your investment goals are:

• Specific: Clear and well-defined, avoiding vague or general statements.
• Measurable: Allow you to track whether you've made progress.
• Achievable: Within your control and reach.
• Realistic: Attainable based on your current circumstances.
• Time-based: Have a timeline for progress or completion.

Align Goals with Life Stages:

Consider breaking down your investment goals into short-, intermediate-, and long-term segments. This approach aligns with natural life stages, such as youth, middle age, and post-retirement years. For example, short-term goals may include reducing debt or starting an emergency fund, while long-term goals could be retirement planning or saving for your child's education.

Prioritize and Adapt:

Prioritize your goals based on their importance to you and the positive impact they will have on your net worth. Understand that your investment goals may evolve over time as your life circumstances, income, and outlook change. Remain adaptable and adjust your goals as necessary to match your current reality and aspirations.

Define Actionable Steps:

Outline both short-term and long-term goals in writing. This helps create a mental framework for your financial decisions and spurs you to take action. For each goal, determine the timeline, the amount you need to save, and the specific strategies you will employ to achieve it. Regularly review your progress and make adjustments as needed to stay on track.

Choose your investment mix

The Vanguard Investor Questionnaire can suggest an asset mix for your goals. This tool takes into account your risk tolerance, investing experience, and time horizon. Research has shown that the proportion of stocks and bonds you own is responsible for 91% of a diversified portfolio's returns over time.

Stocks have had a 10% average annual return over the long run, with a lot of ups and downs along the way. Bonds have returned roughly half as much annually, on average, although with fewer bumps in the road. That means that, all things considered, a stock-heavy mix is likely to return more than a bond-heavy mix over the long run.

If you're investing for long-term goals, Vanguard suggests considering owning stocks and bonds together. This tends to smooth out the bumps in the road. If you're investing for short-term goals, consider investments unlikely to lose value, such as a money market fund, a savings account, or a certificate of deposit.

You can also assemble your own portfolio. Vanguard suggests spreading most of your money for long-term goals among international stocks and international bonds. Once these basic holdings are covered, you can consider a sprinkling of more specialized investments, such as real estate investment trusts or emerging market stocks. Some of these investments tend to be riskier, so they should represent a smaller share of your total holdings.

Consider diversified investments

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio to limit exposure to any single asset or risk. Vanguard suggests two ways to be broadly diversified:

Consider an all-in-one investment

All-in-one investments combine stocks, bonds, and other investments into one fund. These types of investments are growing in popularity. Two of the most common ones are:

• Target-date investments: These blend investments in proportions suited to your estimated retirement year (the target date).
• Age-based funds: These are offered in 529 college savings plans that blend investments suited to when a child is scheduled to attend college.

Both of these fund types become more conservative as the savings goal approaches, reducing the chance of a large loss.

Assemble your own portfolio

You can combine different types of funds to create your own diversified investment holding. Vanguard suggests spreading most of your money for long-term goals among international stocks and international bonds. Once these basic holdings are covered, you can consider adding a small number of more specialized investments, such as real estate investment trusts or emerging market stocks.

Benefits of diversification

• Reduces portfolio risk: Diversification can smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others.
• Hedges against market volatility: Even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much.
• Offers potentially higher returns long-term: A portfolio constructed of different kinds of assets will, on average, yield higher long-term returns.

Drawbacks of diversification

• Limits gains short-term: By protecting you on the downside, diversification limits you on the upside—at least in the short term.
• Time-consuming to manage: The more holdings a portfolio has, the more time-consuming it can be to manage.
• Incurs more transaction fees and commissions: Buying and selling many different holdings incurs more transaction fees and brokerage commissions.

Understand investment types

There are several types of investments to choose from, and the right one for you will depend on your goals and investing style. Here are some of the most common types of investments:

• Stocks: When you buy a stock, you own a piece of the company that issues it. Stocks can be classified in several ways, such as by the size of the company, the industry it operates in, or its market capitalisation.
• Bonds: Unlike stocks, bonds don't give you ownership rights. Instead, they represent a loan from the buyer to the issuer of the bond. Bonds are often referred to as fixed-income securities because they provide regular interest payments.
• Cash investments: These are readily available short-term financial instruments with high liquidity, minimal market risk, and a short maturity period (usually less than 3 months). Examples include money market funds, savings accounts, and certificates of deposit.
• Mutual funds and exchange-traded funds (ETFs): Mutual funds and ETFs are similar in that they both provide investors with a diversified portfolio of stocks, bonds, and other securities. However, they trade differently. Mutual funds are priced at the end of each day, while ETFs trade on an exchange like stocks and have constantly shifting prices throughout the day.
• Hybrid securities: These complex investments combine the characteristics of both stocks and bonds.
• Alternative investments: These involve higher risks and unconventional investment categories.
• Call and put options: Trading options can be complex and requires a higher level of risk tolerance.

When deciding on the types of investments to include in your portfolio, it's important to consider your risk tolerance, investment goals, and time horizon. A good starting point is to determine your asset allocation, which refers to the mix of different asset classes in your portfolio, such as stocks, bonds, and cash investments.

Start with your asset allocation

When choosing investments for your portfolio, it's important to start with your asset allocation. Asset allocation is an investment portfolio technique that balances risk by dividing assets among major categories such as cash, bonds, stocks, real estate, and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time.

For example, while one asset category increases in value, another may decrease or not increase as much. This balance can provide protection against a major loss should things go wrong in one investment class or sub-class. The consensus among financial professionals is that asset allocation is one of the most important decisions an investor can make.

There are several factors to consider when determining your asset allocation:

• Time Horizon: This refers to the number of months, years, or decades you need to invest to achieve your financial goal. If you have a longer time horizon, you may feel more comfortable taking on riskier or more volatile investments. Conversely, those with a shorter time horizon may prefer to take on less risk.
• Risk Tolerance: This is your ability and willingness to lose some or all of your original investment in exchange for potentially greater returns. If you have a higher risk tolerance, you may allocate more money to stocks, whereas if you have a lower risk tolerance, you may prefer more conservative investments like bonds or cash.
• Investment Goals: Consider what you want to achieve with your investments. Are you investing for long-term goals like retirement, or do you have shorter-term goals like saving for a vacation or a new car? Stocks and bonds are typically recommended for long-term goals, while investments like a money market fund, savings account, or certificate of deposit are suitable for shorter-term goals as they are less likely to lose value.
• Diversification: Diversifying your portfolio can help reduce risk. By owning a variety of stocks, bonds, and other investments, you can minimise the impact of any one investment on your overall portfolio. Mutual funds, which pool money from many investors and invest in a diverse range of assets, can also be a good way to diversify.
• Costs: The amount you pay to invest will impact your returns. Lower-cost investments can often outperform higher-cost ones over time, as every dollar you pay to own the investment is one less dollar earning a potential return.

Frequently asked questions