In How to Build a Mutual Fund Portfolio – Part 1 I discussed the basics of mutual funds. In a nutshell, when buying into a mutual fund you’re pooling your money with other small investors and buying a large basket of stocks. By doing so you’re spreading out your money so that bad news for one company will not sink your whole portfolio.
Today I’ll discuss how to use mutual funds to build a portfolio. Let’s assume that you have just started investing and just raised enough money to make your first investment. With mutual funds, that is between $3000 and $5000. Let’s also assume that you have a long time to invest – like 20 years or more.
The first step is to select a good stock mutual fund. Probably the best first fund will be either a large cap stock fund, such as an S&P 500 fund, or a total stock market fund. When choosing between funds that invest in the same things, select the ones with the lowest fees. Because mutual funds are buying a lot of different stocks, they end up with about the same portfolios. Over long periods of time, the ones with the lowest fees will therefore provide the greatest return since you’ll be getting the same markets returns but paying less of your money out in fees each year. The funds with the lowest fees are index funds since they do not need to pay managers to select investments and they do not trade stocks very often. To buy into the fund, just send a check to the fund company or send money through electronic transfer online.
Buying into your first fund is just the beginning. To build wealth, you’ll want to keep contributing money and buying more funds. Think of it as planting a money tree with dollar bills as leaves. You could spend your cash from your salary now, but if you plant a few bills and let them grow into a tree, you can harvest the leaves for ever. You can only harvest a certain number of the leaves each year or the tree will die, but with time the tree gets bigger and you can harvest more. If you then take some of the leaves from the trees and plant those also, you’ll grow more and more trees and be able to harvest more and more leaves. You can earn your money once and then spend it forever.
Your initial investment is just the beginning. Start saving $300-$500 each month. If you have bought into a total stock market fund, just add money to the fund as you go until you have about $10,000 in the fund. If you bought into a large cap fund, when you have saved up another $,3000-$5,000, you are ready to buy into your second stock mutual fund. This time put the money into a small cap fund since that will provide diversification. Sometimes the large caps will do better. Sometimes the small caps will do better. Over long periods of time, the small caps will best the large caps since they have more room to grow. Which will do better over a period of a few years, however, is anybody’s guess, so you want to bet on both horses.
Once you have about $10,000 in domestic stock funds, it is time to think about diversifying out into other types of assets. This will help reduce the ups and downs that you see in your portfolio value. More important, it will ensure you have at least some money in the areas that are hot at any particular time.
If you are nearing the time when you’ll need the money for life expenses, or you just want to have a less volatile portfolio, you should start to put some money into income producing stocks and bonds. The higher the percentage of growth stocks you have, the greater the level of fluctuations in the value of your account will be, so adding income assets will tend to reduce the heart-dropping falls and help you sleep better when the markets are going south. You will also find that you can have a lot more volatility for not a lot greater return if you have a large percentage of growth stocks.
A rule of thumb for a stock-to-bond ratio, which is really a growth investment to income investment ratio, is to invest your age in bonds. In other words, if you’re 20, put 20% in bonds. If you’re 80, put 80% of your money into bonds. If you don’t like the market fluctuations, add more bonds than you age. For example, if you’re 40 but worry a lot, have 50% or 60% bonds. If you don’t mind the fluctuations and want a higher return, invest less in bonds than your age. In fact, if you are several years out from needing the money (like 20 years or more), you might want to have a very small portion of bonds in your portfolio since that portion of your portfolio will not perform as well as the growth stock portion, so you’ll be giving up several percentage points of return. Realize, however, that you can expect some large fluctuations in the value of your account, on the order of 40% or more, during big moves in the market like the 2008 housing crash. You need to have the intestinal fortitude to just hold on for the ride if you choose not to include bonds. The closer you get to needing the money, the more dangerous being in all stocks becomes since you could lose half the value of your account and take five to ten years to recover.
To add bonds/income assets to your portfolio, you can buy a total bond market fund or perhaps a growth and income fund. You can also find a managed fund that lists its objectives as “preservation of capital while providing some growth,” since this type of fund would contain a lot of defensive stocks and bonds. Again, however, managed funds would have higher costs, which would affect your return.
Once you have invested enough into a bond fund or an income fund to provide the growth/income ratio that suits your personal taste for volatility, you would continue to add to both positions. At some point (perhaps when you have about $50,000), you should also consider adding international stocks. The US is not always the best place to invest, and as I said before, you want to always have some of your money in the places that are doing the best at any given time, so adding an international stock fund to your portfolio is a good move. Personally I would invest somewhere around one-quarter to one-third of the stock portion of my portfolio in an international stock fund.
Once you have US stocks, international stocks, and a bond fund you could then stay with that mixture of funds your whole life. You would just add money to the funds as needed to maintain the ratios of stocks to bonds and US to international stocks that you desired, perhaps selling some shares of one and buying shares of another if things got too out-of-balance. This should be done rarely, however, since it can trigger taxes and also reduces your return because you are driving up costs for the fund. Some funds also limit the number of transactions an investor can make to dissuade people trying to time the markets. Really, making a shift once a year at most is fine, while directing new money into the fund that needs propping up the rest of the time. As you move closer to retirement, shift money into the income funds and/or sell outright and build up a cash position for near-term spending needs.
You can also add some other types of assets to your portfolio as it grows. See this more as fine-tuning than a necessity. A Real Estate Investment Trust (REIT) fund diversifies you into real estate, providing both income from rents and capital appreciation from increases in the value of the properties. You can also invest in convertible securities, which provide both an income and a growth component. Finally, you can put a small portion of your account into an aggressive growth fund, which will invest in start-ups and other high risk/high reward ventures, or an emerging markets fund, which invests internationally in companies in third-world nations transitioning into second-world nations. These types of funds will do great some years and really bad during other years.
Probably the biggest thing to remember is that it doesn’t matter all that much. If you invest in at least a couple of funds that invest in different things, keep your costs relatively low, and generally leave things alone, you’ll do just fine. The most important thing is to invest regularly and don’t pull the money out to pay for something that will not improve your finances in the future. Every dollar you invest in your twenties will be hundreds of dollars in your sixties. It is just a matter of letting it grow into a big money tree rather than pulling it out with the roots when it just starts to bear fruit.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.