Guiding Philosophy for Creating an Investment Auto-Pilot for early retirement

[This post is written and copyrighted by FIRE Finance (http://firefinance.blogspot.com).]

We have adhered to the following principles during the creation as well as maintenance of our investment auto-pilot. It must be clear that these principles are useful for those players who are interested in playing the game of investing for long term.

Do not try to time the market - buy and hold.

• The trick to successful investing is to match the market instead of attempting to beat it.
• Once the portfolio is in place i.e. you have finalized your assets' allocations, you only trade to rebalance the asset classes annually.
• Since you are buying and holding except for rebalancing, your capital gains remain compounding in your portfolio tax-deferred. This helps in maximizing returns from your investments over your lifetime.

Keep management fees low.

• Choose investments that have low expense ratios (i.e. management fees). The average expense ratio of the portfolio should be less than or equal to 0.50% per year.
• Choose an online broker who offers the following:
  • charges no fees for buying no load mutual funds.
  • has low trading fees for purchasing stocks/ETFs.
  • offers free dividend reinvestment plans (DRIP).
  • facilitates free ACH (electronic) transfer of funds from your bank a/c to the brokerage a/c.
  • has no a/c minimums or maintenance fees.
  • offers the funds, stocks, ETFs you are interested in.
  • provides IRA (Roth/Traditional) a/cs with no maintenance fees. Having your IRA and investing a/cs with the same brokerage provides a great convenience in analyzing and rebalancing your portfolio at one place.

Select investments with low turnover.

• This principle is based on Warren Buffet's Fourth Law of Motion" For investors as a whole, returns decrease as motion increases [1]."
• The higher the turnover the more are the expenses incurred in maintaining the investment which thereby reduces the returns from the investment.

Allocate/Diversify your investments across several asset classes which compensate each other (i.e. have less correlation to each other) to reduce the volatility of the portfolio.

• This principle emanates from the Modern Portfolio Theory[by Harry Markowitz & Merton Miller which won them the Nobel Prize in 1990].
• In a nutshell, the above theory says that the overall behaviour of a portfolio can take on different characteristics from the behaviour of any single component.
• For e.g. if one of your assets pays off only on rainy days and another pays off only on sunny days, these two risky assets together would produce a nice all-weather portfolio [2].
• In your portfolio keep an additional set of asset classes which are less correlated to the main stock and bond asset classes. This will provide real benefit to the overall results [2]. For e.g. a set of additional asset classes may comprise of real estate, oil and gas, precious metals/commodoties/materials, utilities, and private equity.

Maintain low volatility

• Do not try to achieve the highest rate of return if that means an unacceptable level of volatility or risk.
• Choose a mix of assets to maintain an acceptable level of return at the lowest risk [2].

Use Index Funds/ETFs whenever possible

• Indexes are designed to approximate the returns of different segments of the market and often an index's performance overlaps neatly with its respective asset class.
• Whenever you find an index which matches an asset class you want for your portfolio, your best choice for the portfolio will almost always be the low-fee, tax-efficient index fund or index ETF [2].

Be aware of the required return from your portfolio

• Your portfolio must remain intact or grow against the triple assaults of:
  (1) inflation (approximately 4% per year),
  (2) management/trading fees (0.5% per year) and
  (3) a 4% to 5% annual withdrawl over the long run (i.e. when you retire) [2].
• Adding together the above figures from the three demands, the portfolio needs at least an annual return of 8.5% to 9.5% to keep its real value intact.

Rebalance your portfolio

• Studies have shown that rebalancing once a year is about the right frequency [2]. Rebalancing more frequently is usually counterproductive, and putting it off for 2 to 3 years probably means taking more risk than you had planned for.
• Rebalancing keeps you from succumbing to the all human self-defeating natural urge to keep riding a winning investment while dumping a losing one or trading too frequently.

Update Mar 19, 2009: This philosophy works well when the market is up i.e. a bull market. But when we have a bear market, it would pay to implement some cut offs in your portfolio with respect to your risk tolerance.

For example, when the market fell into its present recession (2008 onwards) we lost nearly 50% of our (six figure) portfolio's value. At this point, we decided to convert our stock holdings (mostly index funds and ETFs) into cash and bonds. We could not bear to see our hard earned savings decline further. You may say we had reached the limit of our risk tolerance.

Nobody knows when a recession would end and the market would recover. Through this experience we learnt in a hard manner about the importance of having an exit strategy in place no matter how long our investing time line is. If you are nearing retirement it is exteremly important to monitor your portfolio and have cut offs to exit the market to preserve your capital. Potential retirees do not have an endless timeline for investing and buy and hold should be used with caution. For them capital preservation should be a top priority.

Let us know your thoughts or opinions about the buy and hold strategy, especially during a bear market. Looking forward towards your comments.

References
[1] Buffet,Warren. "Annual Shareholder Letter - 2005."

[2] Clyatt, Bob. "Work Less, Live More", Nolo Publications, October 2005.

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