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I’ve struggled with this concept. I’ve seen many others struggle with it, too.
Step 1: We discover a new shiny idea (…Roth conversions! …Small-cap value investing! …Qualified charitable distributions!)
Step 2: This idea’s shiny appeal catapults it to the top of our priority list.
Step 3: Blinded by the light, we mistakenly overemphasize this new idea to the detriment of the big picture.
In various fields, this is called a “novelty effect” or “novelty bias.” It affects long-term investors and DIY financial planners, too, as they contemplate retirement and other long-term goals.
What if, instead, we had a simple, prioritized list of ideas that long-term investors ought to consider? Something that wipes away bias and cuts straight to the facts. We need an “order of operations” that ensures you focus on the most important things first, before getting to the shiny new idea.
Math has “PEMDAS.”
Personal finance has “FOO” – the “financial order of operations.”
And what we’re about to do here is “FOO-adjacent,” but much more specific to long-term investors, retirement planning and portfolio construction.
The Long-Term Investor’s Order of Operations
I believe that if you follow this list in order, you’ll be a better long-term investor. Don’t commit too much energy to a lower topic until all the upper topics are fully addressed.
Step 1: Invest
I know, I know… we start with a stunning revelation: the most important step in investing is “invest.”
But the truth is, many people get caught up in small details before they’ve invested enough to make those details matter. Your stock/bond allocation doesn’t matter if you only have $100 sitting in an account. The single biggest dial you can turn is how much you choose to invest.
Consider making consistent investment deposits over time (aka “dollar cost averaging.”). Focus on your savings rate, lifestyle inflation, and career capital.
Step 2: Control Your Temperament
Warren Buffett said,
“Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
Despite what many people think about investing, behavior dominates math. Simple steps, like automated investing and rules-based rebalancing, can be vital. We all possess biases (loss aversion, recency bias, anchoring) that can derail us.
Long-term returns are achieved by staying invested during crashes, avoiding panic selling, avoiding speculative manias, thinking long-term, and choosing process over prediction.
The math is straightforward. Controlling the broad spectrum of human emotion is far more challenging.
Step 3: Risk Assessment & Asset Allocation
Asset allocation describes splitting your portfolio across broad asset types like stocks, bonds, real estate, cash, etc.
Determining a proper asset allocation is related to your personal time horizon and “need, ability, and willingness” to take on risk. Then you must match your asset allocation accordingly.
Your asset allocation explains an overwhelming share of your total return. Said another way: your choice to invest in, say, 80% stocks vs. 60% stocks is far more consequential than which stocks (aka “security selection”) you choose.
Asset allocation >>> Security Selection.
Step 4: Broad Diversification
Next, you must diversify your Asset Allocation percentages broadly.
Stocks, for example, can be diversified across geographies, across industries, across business sizes, etc.
Diversification reduces portfolio volatility, protects against significant losses if one investment fails, and ensures that long-term returns do not rely on the performance of a single security or sector.
This broad diversification provides a better risk-adjusted return.
Step 5: Cost Control
Investing isn’t free. Costs are vital to understand.
Every small cost counts, and those costs compound over many decades. You should understand your expense ratios (i.e. the costs of funds), advisor fees, commissions and trading costs, and other places where you’re paying to invest.
But it’s still true that:
“Costs are what you pay, value is what you get”
Costs are just one half of an important fraction. Value is far harder to measure, but equally important to understand.
Step 6: Account Selection + Tax Location
Different investment accounts have their own pros and cons. Examples include 401(k) and IRA (Traditional vs. Roth versions of these accounts), Health Savings Accounts (HSA), taxable brokerage accounts, childrens’ accounts (529, UTMA/UGMA, Trump).
These accounts are taxed differently. Some accounts allow tax-free contributions or withdrawals. Some accounts allow tax-free growth each year. Some accounts are subject to capital gains taxes.
A general rule of thumb is that “tax diversification” is helpful in retirement, as it allows the investor to react dynamically as tax codes change.
Step 7: Withdrawal Optimization
Building a good portfolio is a separate skill set from withdrawing money (e.g., in retirement). You follow Steps 1-6, yet undo that good work with withdrawal errors.
Investors (especially those investing for personal reasons) have many tools at their disposal to help with withdrawal planning.
Common examples include a “safe withdrawal rate” framework, dynamic spending rules, withdrawal guardrails, sequence risk mitigation, and “bucketing” various withdrawal amounts vs. a total return approach.
Step 8: Legacy, Gifting, and Capital Transfer
Continuing from #7, any money that isn’t withdrawn is gifted, transferred, or left to heirs.
A sound estate plan, a lifetime gifting strategy, and charitable planning are all important parts of a long-term investing plan.
Step 9: Security Selection, Factors, and Tilts
There’s a good reason for basic asset allocation to be Step #3, and broad diversification to be Step #4. They’re that important. But there’s more to investing than just those two ideas.
“Security selection” is the process of choosing individual investment products. Are you investing in Apple, a broad stock index fund, or a mutual fund of energy companies? That’s a security selection decision.
“Factors” are broad, evidence-based characteristics of securities that have historically been associated with differences in long-term returns. Examples include value (cheap vs. expensive), size (small vs. large companies), profitability, and momentum. “Tilting” your portfolio toward one of these factors can be an impactful decision.
Step 10: Tactical Tax Optimization
Many investors find small opportunities to reduce their lifetime tax bill without altering course in their overall investment journey. Everyone pays taxes. But you don’t have to pay more taxes than you’re obligated to.
Specific common tactics include Roth conversions, tax-loss and tax-gain harvesting, and optimizing asset location between accounts of differing tax status.
Smart tax planning compounds.
Step “Never”: Neutral or Outright Negative Behaviors
That leaves us with many all-too-common behaviors that, on the whole, are a net negative for long-term investors. Behaviors such as:
- Market timing.
- Chasing hot stocks.
- Economic forecasting and other macroeconomic predictions
- Political adjustments (e.g., altering your portfolio due to political hopes or fears)
The Order Matters!
Perhaps you’re reading the list and thinking:
- I need to focus on my withdrawal strategy!
- Factors! Sounds interesting. I should look into that.
- Yes, that guy on the radio mentioned ‘Roth conversions,’ and it’s been on my list.
Sure. Those things are part of the process. But I would list those three activities as #7, #9, and #10, respectively. There are far more impactful ways to spend your time and energy!
If you’re taking part in this long-term investing journey, I’d encourage you to work through this “long-term investing order of operations” in order.
Master each step in order and happy investing!
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