Rule #2: Don’t Over-Think Your Investments.

A reader asked me if I could break down my ideas into a handful of principles. After some careful thought, I came up with a list of fourteen basic “rules” that summarize my money and life philosophy. I’ll be presenting these as a weekly series.
I picked up a copy of Money recently and counted the number of mutual fund ads in the issue. My count? 18.
Each one claimed to offer some sort of security for you. Each one claimed to offer superior service and/or superior results.
Then I turned to the content. I saw a huge list of mutual funds, all of which seemed to be described as spectacular. I saw multiple articles discussing how to make saving for retirement or saving for college as complicated and scary as possible.
By the time I sat the issue down, I was almost overwhelmed. With that many investment options and choices out there, how can I possibly ever pick the right one?
The truth? Don’t worry about it.

You’re twenty five. You want to retire at age sixty, so you’ve got thirty five years to go. You decide that $750,000 is a good target. So you start looking into investments.
You do a week’s worth of research, pick an investment that seems pretty good and stable over the long haul, and you decide to dive in and start saving right then and there.
You start socking away $5,000 a year, and that investment only has to earn 7% a year to get you to your goal. You don’t have to have sleepless nights worrying about your investment – 7% is a pretty reasonable goal.
Now, let’s say you look at them – and you’re overwhelmed. You decide to wait a year – and that year becomes five.
You start socking away $5,000 a year now, but the outlook is decidedly worse. You now have to earn 9% a year in order to make that $750,000 goal. Instead of being able to sock that money away and not worry about it, you’ll now have to micromanage it – and even then, you likely still won’t make it.
What’s the moral of the story? You’re better off starting your savings now rather than waiting until you find the “perfect” investment. The perfect is always the enemy of the good. Sure, you can keep your eye out for a better investment, but you don’t have to have world-beating Peter Lynch-like returns in order to make your goals.
So what’s a “good” investment? For starters, an index fund: they’re easy and don’t require much time investment, they’re very cost efficient, and they outperform virtually all managed mutual funds. Burton J. Malkiel, in his seminal The Random Walk Guide to Investing, makes a brilliant case for them:

[Index fund investing] has outperformed all but a tiny handful of the thousands of equity mutual funds that are sold to the public. Let’s list all the advantages of an index fund strategy:
– Index funds simplify investing. You don’t have to choose among the thousands of individual stocks and mutual funds available to the public.
– Index funds are cost-efficient. [Many] have no sales charges and have miniscule expense charges. Moreover, index funds do a minimal amount of trading. Thus, they avoid the very heavy transactions costs of actively managed funds, which tend to turn over their entire portfolio about once a year.
– Index funds regularly produce higher returns for investors than do actively managed funds.
– Index funds are predictable. You know beyond doubt that you will earn the rate of return provided by the stock market. Yes, you will lose money when the market declines, but you will never own the fund that performs several times worse than the market.
– Index funds are tax-efficient. If you do own stocks in taxable accounts (that is, outside your IRA or retirement plan), then you need to invest in index funds that don’t trade from security to security and therefor don’t tend to generate taxable gains.

Another great summary can be found in the excellent article The Best Investment Advice You’ll Never Get at San Francisco Online.
But what about stock market downturns? Obviously, putting all your money into a stock index fund puts you completely at the whim of the stock market – and as many people discovered in 2008, that’s not a good thing at all.
Whenever I think of the downturn of 2008, I think of my mother- and father-in-law. Their retirement plans hit such a serious roadblock that they went from hinting vaguely at retirement (and the requisite travel and spending time with grandchildren that would come with it) to joking about working until they fall down dead on the job.
How do you protect yourself against that, huh? The trick is diversification, especially as you get closer to retirement. When you’re a long way out – thirty years or more from retirement – it doesn’t hurt to bet quite a bit on the big return – but with that big bet comes big risk. If you have everything in stocks and the stocks drop, then everything you have saved drops.
So, as retirement gets closer, you’re well-served to gradually move things out of stocks and into bonds, real estate, cash, or other investments. You’re no longer trying to hit home runs – you’re happy just to not strike out when your retirement comes close. So diversify.
Again, many investments make that easy. Most plans offer some version of a “target retirement” plan that will do just that for you. As you approach your retirement age, the plan will gradually – automatically – shift money from a heavy stock investment (great when you’re young and can afford to swing for the fences and risk a strikeout or two) to a very diverse investment (best when you’re older and you can’t afford to strike out).
That’s all there is to it. Start saving now, preferably in a target retirement plan made up of index funds. You can watch for better investments if you want to, but the sheer advantage of saving now in a low-cost plan that automatically diversifies for you as you get older will be hard to beat.
Roth IRA? 401(k)? I don’t know what to do! Here’s the truth: they’re both pretty good. In either one, you’re not hit with tax penalties for diversifying your retirement savings. Given that we don’t know what the tax rates will be in thirty years, it’s impossible to say which one is better, and people will argue until they’re blue in the face without being able to come up with a real answer.
A general good rule of thumb is to contribute to your 401(k) up to the maximum amount that your employee matches (because employee matching is basically free money). If you want to save more, start a Roth IRA (because you have more investing choices).
However, the importance of actually saving blows away the differences between the two. You’re light years better off simply throwing everything you can into savings than sweating about which investment option is the best. Again, the perfect is the enemy of the good.
What about college savings? Virtually the same exact principles apply to college savings as apply to retirement savings. Saving now is the most important thing, and diversifying as you get close to the big day is vital, too. Just pick a good 529 savings account – preferably one like Iowa’s that has a “target graduation” investment option – and start socking away the money now.
That’s really all you need to know about investing, for all practical purposes. The earlier you invest, the better. If you can, use a plan that enables you to invest with tax protections (Roth IRAs, 401(k)s, 529s). The farther away you are from the event you’re saving for, the more heavily you should invest in stocks (high risk, high reward). The closer you get to your big event, the more you should diversify (lower risk, lower reward).
I use Vanguard for pretty much all of my investments – they make all of this so easy that once you’ve set it up, you barely have to think about it again. I know that if the stock market dips again, I don’t have to panic – my short-term stuff is safely out of stocks and my long-term stuff has plenty of time to recover. I know I’m investing now rather than later, giving compound interest plenty of time to work in my favor.
It all just works – and for all of the complexity that publications like Money try to throw into the mix, that simplicity is what we all strive for.
Remember: don’t overthink things. The perfect is the enemy of the good, and if you get obsessed with the perfect, you’ll lose the good along the way.

http://www.thesimpledollar.com/rule-2-dont-over-think-your-investments/