(Money Magazine) -- Question: I just sold my house and have $300,000 to invest. Everyone has suggestions, but what do you think I should do? -- John, Pacific Palisades, Calif.
Answer: I'm sure you're getting all kinds of suggestions about where to invest your money from relatives, friends, co-workers and, of course, from people who peddle investments and financial services. And, who knows, some of the recommendations may even be helpful. For example, maybe some sensible person has already intimated that before you invest a dime, you may want to check out IRS Publication 523 to see how much, if any, of the sale proceeds you may want to set aside for taxes.
The problem, though, is sorting out the truly useful suggestions from those that are worthless, impractical, harmful and self-serving.
So rather than just contribute to the din of voices tossing out specific investments -- Buy gold! Energy stocks! No, currencies are the place to be! -- I'm going to recommend a way to sort through the information overload.
With that aim in mind, I've come up with three questions that I believe all investors, from neophytes to veterans, should ask themselves. If you think about these queries and give serious and thoughtful answers, I think they can sharpen your focus and help you make more reasonable decisions when investing your three hundred grand.
Question 1: What am I investing this money for?
Forget about investing for a moment and think instead about what you would do if you were in the market for a car. How would you sort through the hundreds of choices? Undoubtedly you'd consider factors like safety ratings, price, resale values, and dependability. But that's not how you would start. No you would begin by thinking about how you plan to use the car.
If you know you'll need a vehicle to shuttle your kids, their friends and their athletic gear to and from little league and soccer games, you would know to not even bother looking at a muscle car like a Chevy Camaro. If, on the other hand, you want something that's sleek, a blast to drive and that might act as a chick magnet to boot, you're not going to buy an eight-passenger minivan.
You should be going through a similar thought process when it comes to investing. How are you going to use the money once it's invested? Any part of your stash you think you might need to tap within the next couple of years -- say, for emergencies or perhaps to make a down payment on another house -- should be invested where the principal and earnings won't be at risk. As I've noted before, that largely relegates this portion of your 300 large to secure investments like FDIC-insured savings accounts, money-market accounts, and short-term CDs.
The money you know you can leave invested longer-term you can afford to take some prudent risks with, which means divvying it up between stocks and bonds (or, more likely for someone with the amount of money you have, stock and bond mutual funds). The longer you plan to keep the money invested, the more you can tilt the mix toward stock funds, the idea being that you can ride out short-term fluctuations in stock prices in hopes of earning equities generally higher (although by no means guaranteed) long-term returns. The sooner you think you may have to dip into your investments, the more you'll want to emphasize bond funds.
For guidance how to arrive at a stocks-bonds mix that's appropriate for you, I suggest you read our MONEY 101 lesson on Asset Allocation and then check out our Asset Allocator tool. Creating the right portfolio is a bit trickier if you're relying on your savings for income in retirement. For suggestions on that score, you can click here.
Question 2: What investments do I need to achieve my goal?
When Socrates strolled through the marketplaces of ancient Greece, he would look around and remark, "How many things of which I have no need!"
I think he'd feel much the same way if he were alive today and looking at the vast array of investments competing for investors' attention and dollars. Which is to say that just because there are thousands of choices available doesn't mean you need them, or for that matter, even need to consider them to be a successful investor. In fact, research shows that an overwhelming number of choices can add more confusion and complexity than value.
So don't even waste the mental effort of evaluating exotica like leveraged ETFs or single country funds or the hundreds of sector funds and ETFs that dabble in narrow niches of the market. Instead, you should aim to build a portfolio of stock funds that covers the main segments of the stock and bond markets. For equities, you want large- and small-cap stocks and growth and value shares. As for the bonds, you want funds that give you access to both government and high-quality corporate issues (and, depending on your tax bracket, municipal bond funds for bonds held outside tax-advantaged accounts).
You can do this by picking individual stock and bond funds that cover these areas. Or, to make it simpler, you can get pretty much all you need (except munis) with just two funds: a total stock market index fund and a total bond market index fund. Either way, you'll find what you need on our Money 70 list of recommended funds.
Frankly, if you stopped there, I think you would do fine. But if you like, once you've covered the basics, you can branch out further by adding a diversified international fund and, for inflation protection, a real estate or natural resources fund to your stock holdings and a TIPS, or Treasury Inflation-Protected Securities, fund to the bond portion of your portfolio.
Don't overdo it, though. The potential for adding extra value diminishes as you add more and more investments -- and the possibility of snafus increases. Besides, the more your portfolio looks like one of those multi-colored pie charts of a dozen or more investments, the more time and effort you'll have to devote to managing it.
Question 3: What am I paying for my investments?
Most investors spend too much time focusing on returns (over which they have little to no influence) and not enough on investment costs (which they largely can control). I contend you'll dramatically improve your chances of investing success if you do the opposite. That's especially likely to be the case if we're in an era, as many people believe, of generally lower expected returns.
Why home in on costs? Well, not only are expenses more predictable than returns, they also reduce dollar for dollar the amount of return that you get to keep. And the amount of money fees and costs suck away over the long term can be substantial. How substantial?
Well, to gauge the effect of costs for a Money Magazine storyearlier this year, I revved up Morningstar's Principia program and sorted all large-cap mutual funds with 15-year records into four groups based on their annual expenses. I then compared the average annualized 15-year return of each group. Result: the higher a group's average fees, the lower its average return. Indeed, the 7.6% average annualized gain for the lowest-cost group was fully 1.3 percentage points higher than the 6.3% average for the funds that charged the highest fees. On a $50,000 initial investment that disparity translates to having $150,000 vs. $125,000 after 15 years.
Obviously, every fund with low expenses won't outperform every one saddled with higher fees. There will always be exceptions. But why try to buck the odds when it's so easy to identify cost friendly funds using Morningstar's Fund Screener or by perusing the low-fee options on the Money 70.
So I recommend you tune out the suggestions and set aside some time to think about your answers to the three questions above. Or you can keep listening and evaluate each new pitch as it comes in -- and hope that all those disparate ideas will somehow gel into a coherent whole.
Do you have an 800-plus credit score? Or have you pulled your score up past 700 after a financial setback? If you'd like to talk about it for an upcoming issue of MONEY magazine, send your name, age, phone number and a few details about your story to firstname.lastname@example.org.
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