The 50 Percent Rule - A Simple Investing Strategy

OK. Here is the promised simple strategy for investing. In this column, I'll just give the recipe for the strategy, and I'll devote future columns to explaining how it works and how to modify it for different purposes.

The purpose of this simple strategy is to grow your investment at a reasonable rate, while reducing the chance of catastrophic losses. The first part of this strategy has to do with asset allocation. Take all of the money that you have to invest, and divide it into three piles:

• 50% for investing in stocks
• 40% for investing in bonds
• 10% to keep in cash

Investing 50% in stocks is why I call this strategy "the 50 percent rule".

Keep in mind that you should always have six months worth of salary in cash (see my earlier column on the prerequisites to investing). The 10% kept in cash here can count towards that six month salary total.

The second part of this strategy is to use exchange traded funds (ETFs) to minimize the risk involved in purchasing individual stocks and bonds.

• With the money designated for investing in stocks, purchase SPY. SPY is a fund that mimics the performance of the Standard and Poor's index of 500 large cap domestic stocks. It is a broad index that will rise and fall with the overall stock market. It also pays a dividend that is currently running around 1.9%.
• With the money designated for investing in bonds, purchase AGG. AGG is a fund that tracks the performance of the total bond market. Since bonds pay interest, AGG also pays a dividend, which is currently yielding around 3.3%.
  
• The money that is kept in cash will be automatically invested in a money market fund by your broker (see Selecting a Broker).
  

The third and final part of this strategy is to rebalance annually. Over time, the allocations will change. The dividends from stocks and interest from bonds will increase the amount of cash in the account. Fluctuations in the stock market will cause the value of your investment in SPY to increase or decrease. The same is true with AGG.

Once a year, you should correct the allocations to bring them back to the recommended percentages. For example, if the stock market has declined, and the bond market has rallied slightly, after a year your allocation might look like this:

• 45% SPY
• 41% AGG
• 14% cash

This means you should sell enough AGG to reduce its allocation to 40%, and purchase more SPY, to bring its allocation back to 50%. That is called portfolio rebalancing.

This rebalancing should be done once a year. I do it at the end of January or beginning of February each year, because that is when most companies report their annual results.

So that's the whole strategy. As you save money, you can add it to cash, and let it be rebalanced into other investments annually. If you need to raise money, take it out of cash. Don't let the cash level drop too low, however. If it falls to 5%, you should do a rebalancing to bring it back to the 10% level.

Selecting a Broker

OK, if you've met the requirements for beginning to invest (see my previous entry on the prerequisites to investing), the first step is to select a broker and open an account with them. When I'm choosing a broker, the things I look for are: online trading, low fees, good execution, and a nearby office. It's useful to check out articles like the annual Smart Money list of top brokers. You can also google for "Top rated online brokers", and get lots of similar articles.

By coincidence, the top three brokers on the list this year (2011) were all brokers that I currently use. They are Fidelity Investments, Scottrade, and TD Ameritrade. These all have offices nearby, and they all support online trading. Their fees range from $7.00 to $10.00 per trade.

One of the themes of this blog is that you need to be responsible for your own investing. You can ask a broker for advice, but the sad fact is that no one cares as much about your investments as you do. When you get advice from a broker, that advice is influenced by the products that the broker's company is selling. Another problem with financial advice is that it is often generic, rather than tailored to your specific situation. A third problem with financial advisors is that some of them are incompetent or outright crooks.

If you don't understand enough to do your own investing, then how can you tell the good advice from the bad advice? That's why I recommend opening an account that supports online trading, so you can make your own trades without going through a broker.

Of course, the big question is, how do you get the knowledge to do your own investing? That's what I'll be talking about in the future. For now, one resource you can use is Investopedia. It's got a handy dictionary of investment terms, and regular articles on different topics.

In the next few entries in this blog, I will describe a simple investing strategy that works in all different kinds of market conditions.

The Prerequisites to Investing

You might think that all you need to start investing is some money. But it's not that simple. When you invest, you put money at risk. That's a fancy way of saying you might lose the money. For example, if you buy stocks or bonds, those investments can become completely worthless if the company goes bankrupt. Even a company that is doing OK can see its stock dramatically drop when the business climate changes.

So when is it safe (and worthwhile) to take this kind of risk? That's what these prerequisites are really about. Here's the list of what you should have before you begin investing:

1. A steady income that provides you with enough to live on plus a little more. See Getting Started (rule #1).
2. No credit card debt, or other "bad" debt. See Getting Started (rule #2) and Good Debt and Bad Debt. It's OK to use a credit card as long as you pay off the balance each month. Then you aren't really incurring debt.
3. Substantial equity in a home. I'll say some more about this below.
   
4. Savings that amount to six months of your income (your combined income if you are married).
5. Health insurance, and also Life insurance if you are married.
   

The point to these prerequisites is to make sure that money you invest is money that you can truly afford to lose. If all your investments fall to zero, and you are laid off from your job, then the savings are there to see that you will have some time to find another job.

The insurance prerequisites are necessary to cover unexpected but potentially catastrophic events. Without health insurance, for example, your entire savings and investments could be wiped out by a sudden illness. Many jobs provide insurance as one of the employee benefits, but if you are self employed, or your job doesn't provide insurance, then you should purchase insurance for yourself (and your family) before even considering investing.

This brings us to the home. Why own a home before starting to invest? The reason is that a home is really your first and your best investment. It not only provides you a return on your investment, it also gives you a place to stay, and saves you the rent you would otherwise pay. On top of that, the government subsidizes your investment by giving you a tax break on the interest payments on your mortgage.

Your equity in a home is the value of the home minus the amount of the mortgage. So if you bought a $300,000 home, and borrowed $250,000 to buy it, then your equity is $50,000. Over time your equity increases as you pay off the mortgage. Substantial equity is at least 20%. So in the example of a $300,000 home, you should have at least $60,000 in equity before considering investing.

There are lots of things to consider when buying a home, I could write another column just on that topic. But there is one thing which is so vital to your financial health, that I have to mention it here. Never buy a home using a variable rate mortgage. The standard mortgage is a 30 year fixed rate, and that is the way to go (or a 15 year fixed rate if you can afford it).

With a fixed rate, you know what your costs are in advance, and you can determine if you can afford the home. As long as the payments are within your means, and you plan to stay in the area for a while (five to ten years), the home should be an excellent investment. The equity in your home provides you with a margin of safety against the normal fluctuations in home value.