Implementing the Sigma Strategy

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Now that we have described the Sigma Investing Strategy, we’ll present here the actual steps that you will need to make to implement this strategy. Again, here are the principles of the strategy followed by some steps to implement it.

Principles

1. Passive management – use index funds or ETFs (exchange traded funds) instead of actively managed mutual funds (or stocks) that try to beat the market

  • It’s hard to beat the market in any case but when you add on additional high management fees and trading expenses, you’re fighting too much of an uphill battle

2. Try to find funds with really low fees (including management fees, trading fees and redemption/purchase fees)

  • Vanguard is great for this – their index funds have really low management fees and the company is a non-profit so their interests are aligned with yours
  • Some ETFs also have really low management fees and track the same indices as Vanguard’s funds

3. Tax manage

  • Index funds and ETFs will pay dividends and realize capital gains during the year that are passed onto you – you will be taxed for this
  • If possible, keep your funds that will pay higher dividends (like REITs, treasuries) or cap gains (value and emerging market funds) in tax-free accounts (IRA accounts if you have them)
  • Consider ETFs more strongly because they have an arbitrage mechanism that reduces the amount of cap gains that will be realized while you hold them. Vanguard’s ETFs are a bit different and don’t fully realize this benefit.

4. Rebalance periodically

  • This is the key step which will force you to sell off high performing segments and move the money into the underweighted portions of your portfolio

Following this strategy should ensure good performance over the long run with very low likelihood that your final position will be disappointing. It avoids the risk of hopping into hot asset classes and getting crushed when the prices collapse. You’ll miss some great opportunities but you’ll also avoid the big losses (which more people sustain).

Here’s how you can make a transition into this strategy. We’ve done a decent amount of the legwork so you should take advantage of that.

Implementing the Strategy

1. Open a Vanguard account

  • Even if you don’t buy their index funds, their brokerage services are very cheap
  • Get out of your existing actively managed, high expense mutual funds. Many mutual funds run by Fidelity or T Rowe Price (which are actually not even the highest cost funds) have active funds with management fees of 0.8% to1.25% (the extra 1% per year in performance loss is quite meaningful when compounded over 30 years)

2. Determine your asset allocation based on when you’ll need the money (we focus on retirement money – so you might have about a 20-30 year horizon)

  • If you don’t plan to need the money for 10 years plus, you should probably put less than 20% in fixed income (treasuries and inflation protected treasuries).
    • This part is more a personal choice – it depends on how much you are willing to potentially lose during your investment period. One author has a scale where if you can stomach a 35% overall loss during your horizon, you should be 80% equity whereas if you can only take a 10% loss, you should be 70% fixed income.
    • You want the equity bias though as the expected returns for stocks and real estate are larger than bonds
    • Here is a sample aggressive allocation (you should look up the historical returns for these asset classes to get a feel for the magnitude of the returns vs. the variance)
    • 45% US Equities (15% Large Cap, 15% Large Cap Value, 7.5% Small Cap, 7.5% Small Cap Value) – might be a bit heavy on this asset class
    • 30% international equities (18% developed markets and 12% emerging markets)
    • 15% Real Estate
    • 10% Bonds (5% US Treasuries and 5% US Inflation Protected Treasuries)
  • Less aggressive may be 30% US Equities, 30% International, 20% Real Estate and 20% Bonds.

3. Pick your funds

  • We did some research into some of the best places to put your money based on low management fees, turnover and existing capital gain liability. Here is a link to a summary page: Index Fund and ETF Expenses. Note some of the prices for Vanguard are for their Admiral shares where you need a decent amount of money in the fund. The fees for non-Admiral shares are usually about 0.1% higher. Also, this research is not exhaustive – Fidelity does have some cheap index funds as well – but we think that the expenses are at such a low level that choosing anything from our list is definitely not a bad choice.

  • This is what we suggest for the above aggressive portfolio – mostly ETFs due to similar expenses as Vanguard but they have the tax advantage
    • Spiders 500 (SPY) 15%
    • iShares S&P 500 Value (IVE) 15%
    • iShares S&P 600 Small Cap (IJR) 7.5%
    • iShares S&P 600 Small Cap Value (IJS) 7.5%
    • iShares MSCI EAFE Index (EFA) 18%
    • iShares MSCI Emerging Markets Index (EEM) 12%
    • Vanguard REIT ETF (VNQ) 15%
    • iShares Lehman 7-10 year bond fund (IEF) 5%
    • iShares Lehman TIPS fund (TIP) 5%

4. Consider moving your money into these funds gradually

  • You might want to dollar cost average your initial investment by dividing your money into x equal size chunks and then investing 1/x of your money on a quarterly basis. This reduces the odds that you invest everything right before the market drops. You can do this over a 2-4 year period – so divide up your money in 8 to 16 chunks.

5. Schedule your rebalancing

  • Put it into your Outlook calendar to rebalance (definitely once per year) – Again, this is crucial for your performance and building the discipline to stick to your strategy

6. Put more money in over time

  • Do an automated deposit from you paycheck into a money market account and then buy shares of your assets periodically with this money (you can do this in such a way that it rebalances your overall account)

The Easier Way

In terms of implementing this strategy, there are two other easier approaches:

  • Hire someone to do this for you – just make sure they are following the strategy that you want (rather than actively investing your money). But, they can do the rebalancing and a few more tax tricks that could save some cash. May be expensive though.

  • Vanguard has single funds designed to mimic this asset allocation strategy. These funds include LifeStrategy, Target Retirement and Balanced Index. Take a look at our page about the Target Retirement Fund. They all have different asset allocations and take care of the rebalancing for you. Just deposit money into them consistently. You’ll give up 1-2% of annual return versus doing more of it yourself but it is definitely easier. Of particular interest are their brand new Target Retirement funds. They have a bunch – one is called Target Retirement 2040 which has an asset allocation heavily weighted towards stocks right now. As you get closer to 2040, the allocation shifts to more fixed income. Fees look low as well.