The Basic, All-Purpose, Master Mutual Fund Investing Portfolio


(This is part of a series of articles to teach those who are new to investing how to invest.  To find other articles in this series, choose “Beginner Investing Class” under “Investing” in the menu at the top of the page.  If you have questions or you’d like a topic to be covered, please leave a comment at the bottom of the post.)

Perhaps you’ve tried baking and found an all-purpose, master bread dough recipe.  This is a basic recipe that can be shaped in a variety of different ways, perhaps to make loaves of bread, cinnamon rolls, dinner rolls, and maybe even morning pastries.  Perhaps this master dough could even be used to create the crust for a pizza.

To start out our lessons on learning to invest, we’ll begin with a basic mutual fund investment portfolio and build from there.  Think of this as a master dough for your investing needs.  This is a general portfolio that would be suitable for almost anyone who was planning to invest for at least five years before needing the money.  Once we introduce the basic portfolio, we’ll then talk about why it is designed the way that it is, then tweak it a bit to show how you can adjust it to meet your particular needs.

So what about people who need the money in less than five years?  Investing involves taking a calculated risk with your money to get a higher return than you could with things like bank CDs and savings bonds.  In our case, we’ll be investing in stocks, corporate bonds, and real-estate portfolios.  Part of investing is to put the odds well in your favor.  One of the easiest ways to do this is to invest for long periods of time.  Over less than a five-year period, history has shown that stocks, bonds, and real-estate can produce a positive or negative return, and these returns can vary widely.  Over a period of at least five years, there has almost always been at least positive return.  Over periods of fifteen years or longer, there has always been a positive return and a return averaging about 12-15% per year for stocks.  Because we’re talking about investing, holding periods of at least five years are expected.  If you need the money before that, bank CDs or some sort of government bonds are the way to go since their returns are predictable, if also boring and low.

Before we go too much further, let me highly recommend that you pick up a copy of The Bogleheads’ Guide to Investing.  This book will go into a lot of the details behind how mutual funds work and why you should buy certain types funds (index funds).  It also gives great advice on things like life insurance.  If you buy a copy by clicking on the book cover below and going through Amazon, it won’t cost you anything more than it would if you bought it elsewhere, but I’ll get a couple of dollars from Amazon.  If I get enough of these commissions, it keeps me wanting to write more great articles like this one instead of going fishing, so it is really in your best interest too if you like good free web content.  Just saying.

The Basic, Master Portfolio

As promised, we’ll start out by providing the investments in the basic, master portfolio.  This is the “what,” given before the “why” and the “how.”  Those details will come later.  Please don’t confuse the portfolio (which is a set of investments) with an investment account (which is the wrapper that holds the portfolio).  The basic, master portfolio could be a portfolio held in a standard brokerage account, in a retirement account such as a 401k, 403B, or an Individual Retirement Account (IRA), or it could be held in an Educational Savings Account (ESA) or a Health Savings Account (HSA).  Each of these accounts is just a place to hold the investments.  It is not an investment itself. 

If this is confusing, think of the accounts like types of automobiles and the investments like passengers.  The investment account functions in some fashion and has certain rules for its use, but you can put any assortment of investments into the account, just as you could put any combination of passengers into a given car, truck, dune buggy, or minivan as long as they would f0it.  Different types of accounts are generally suitable for different purposes, just as different vehicles have different uses.  You would not use a retirement account when you were 23 years-old, for example, to save up money you want to use to buy a house in ten years just as you wouldn’t use a sports car to drive down a jeep trail to a campsite.  Certain accounts are also more suitable for certain types of investments.  You might not want to put a high-yield bond fund into a standard brokerage account because of the taxes you would pay, for example, just as you might not want to put your toddler with a box of nuggets and a milkshake in your Corvette.

The basic, master portfolio is composed as follows:

20% General Large-Cap US Stock Index Fund

20% General Small-Cap US Stock Index Fund

20% International Stock Index Fund

20% General US Bond Index Fund

20% US Real-Estate Investment Trust (REIT) Fund

Each of these investments is what is known as a mutual fund.  With a mutual fund, a group of people pool their money together and have a professional investment manager invest the money for them, with everyone in the mutual fund owning a portion of the investments in proportion to the amount of money they invest.  For example, let’s say that you and the 500 people at your work each put money into an envelope and then hired someone to buy a set of investments with the money.  If the envelope contained $100,000, perhaps the manager would buy a portfolio consisting of ten different stocks with $10,000 invested in each.  If you had put $1,000 into that envelope, you would own 1% of the portfolio, meaning you would have $100 invested in each of the stocks.  If the stocks in the portfolio then went up and the portfolio was now worth $150,000, your portion of the investment would be worth $1500.

Furthermore, each of these is an index fund.  We’ll get into what index funds are and why you want them in later articles.  Let’s just say for now that with an index fund, rather than having a manager choose investments for you, he has a specific list of what she is supposed to buy.  This makes it really easy since the manager doesn’t need to spend time picking stocks and doing all sorts of research to do so, which makes the cost to the investors low.  Realize that the salary for the mutual fund manager and all of the travel and things she needs to buy to do research comes out of the fund, so the more you need to pay the manager, the more money gets sucked out of the fund each year.

So What’s in this Basic, Master Portfolio?

The master portfolio is made up of five different funds, each investing in different things.  We’ll get into why we spread the money out like this later, but for now let’s just say it is for something called diversification, which is a way of reducing your risk.  Investing is all about maximizing your returns while making it very unlikely that you will lose money.

The large-cap US stock fund invests in big companies headquartered in the United States.  These are household names like Apple, Alphabet (Google), Amazon, Procter and Gamble, Home Depot, Wal-Mart, and McDonald’s.  Some large-cap funds have the words “large-cap” right in their titles.  An S&P 500 fund, which invests in a list of stocks called the “S&P 500,” is a very common large-cap US stock fund.

The small-cap US stock fund invests in little companies that you’ve probably never heard of, but some of which you will hear lots about in a few years.  These are the little, fast-growing companies.  Some of these companies will make you a lot of money (think if you’d bought Amazon and Ebay back in the early 1990’s).  Many others will disappear and never be heard of again (think of Pets.com and WebVan, also from the mid-1990’s).  On average, you’ll make money by investing in a whole bunch of these small companies since those that become Amazon will make up for those that become WebVan.  The Russell 2000 is a commonly used list of small-cap US stocks.

The international stock fund buys stocks in non-US companies.  This could include companies based in countries in places like Europe, Asia, and South America.  (Yes, for our neighbors to the north, it could also be Canadian companies.)  It might also mix in a few developing countries in Africa or Central America where there is a bit more risk because the political system is a bit unstable, but there could be a huge reward if things work out.  For example, there are a huge amount of valuable resources in the Congo, but there have been many civil wars and coups in the past.  You might have a company there that is very profitable, but then a group of rebels take over the headquarters and take all of the equipment, making your investment worthless.

The bond fund buys bonds, which are loans made to companies and government entities.  Because you receive interest payments from these loans, and because most of the loans will be paid back if you wait long enough, bonds are generally less risky than stocks if you hold them for a long period of time.  Because they are less risky, however, your potential returns will be less than they will be for stocks.  You, therefore, want to have some bonds, but not all bonds.  20% of your portfolio in bonds is a good starting point that can be adjusted up or down, depending on the amount of risk you are willing and able to take, plus the amount of time you have before you’ll need the money.

Finally, the REIT buys a set of properties.  For example, REITs buy groups of office buildings, apartment buildings, malls, and even storage sheds and cell phone towers.  Chances are, the shopping mall near you and that big office building in downtown are owned by an REIT.  REITs both collect rents and sell properties for a profit as the land and buildings increase in value.  Because they are radically different from stocks or bonds, they provide yet another leg to your portfolio.  (Again, we’re doing that “diversification” thing.)

So there you have it – the master portfolio.  In the next article, we’ll break it down a little more and explain why we’ve made the choices we’ve made.  We’ll then talk about ways that you can adjust this basic portfolio to meet your risk tolerance and your needs.

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of Investing.  

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How A Target-Date Fund Works


A target-date fund is a great choice for those who want to invest for retirement but don’t want to spend time learning to invest.  In fact, it is better for you to use a target date fund if you don’t know what you’re doing than it is to not know and not try to learn, yet try to manage your retirement plan anyway.  Unfortunately, many people try to do so and end up jumping from fund to fund (trying to chase returns), staying all in cash (because of fear of loss), or staying all in stocks too long (trying to maximize account balances before retirement).  Each of these mistakes could leave you far short of your monetary needs in retirement.

If you are putting at least 10% of your gross pay into a 401k or similar retirement investment plan, before any employer match, you should be set for retirement.  The main reason you would not be is because you make one of the mistakes mentioned above.  Chasing returns normally means that you are buying stocks high and selling them low, resulting in returns way below those that you would have gotten if you had just stayed in the markets and rode out the ups and downs.  Staying all in cash may seem safe, but it actually guarantees that you will end up with a negative return if you include the effects of inflation and denies you all of the benefits of investing.  Being invested entirely in stocks too long, hoping to make a big score before you retire, can lead to a huge loss right before you need the money.

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So why is a  retirement date fund a good way to avoid these issues?

Think of a target date fund (TDF) like an automatic transmission in a car.  While someone who is skillful with a manual transmission can get better gas mileage or get from 0 to 60 faster than someone using an automatic transmission, someone who doesn’t know what they are doing can easily break something or get worse performance.  Someone who is skillful at investing can do better choosing funds than someone who uses a TDF, but someone choosing funds who is not willing to do the (small amount) of extra work involved or who just guesses blindly can end up breaking their retirement fund.  A decent TDF will get you 90% of the way to your retirement goals.  Choosing funds can get you that extra 10%, which could be millions of dollars, but might just mean that you retire with $4 M instead of $2 M.  Someone managing their account badly could retire with $0.4M instead, which could be a very meager lifestyle.

A TDF does several things automatically for you.  Specifically it:

  1.  Diversifies your investments among different asset classes.  In simple terms, it spreads your money around so that you’ll always have some of your money in whatever is doing well and not have all of your money in whatever is doing badly at any given time.
  2. Adjusts your investment as you get closer to retirement.  As you get closer to the time when you’ll need the money, it shifts from growth investments, which have a great long-term return but have very unpredictable returns over periods of a few years, to fixed-income assets, which return less but are more predictable.
  3. Rebalances your portfolio, selling what has done well (selling high) and buying what has not done as well (buying low).

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How to Use a TDF

Inside your retirement plan (or on the website for a mutual fund company if you’re using a private IRA to save for retirement) you’ll probably fund several TDFs with names like “Retirement 2060”, “Retirement 2070”, and so on.  The number refers to the retirement year for which it is designed.  For example, a 2060 fund would be designed for people who are planning to retire around the year 2060.

To use a TDF, just:

  1.  Figure out your retirement age (pick when you’ll be about 65 or 70 – more on that in a minute).  For example, if you’re 25 today, you’d be retiring around the year 2058, so you would select the 2060 fund.
  2. Once you find your fund, direct all of your investments there.
  3. Don’t touch anything – you’re done.

Let’s go through the reasons for each of the steps above.

Why pick 65 or 70?  What if you’re planning to retire at age 50?

Even if you’re planning to retire 15 or 20 years early, you won’t want to invest like you’re 15 or 20 years older than you are.  TDFs invest more aggressively while you are far away from retirement, then get more conservative as you start to get near your retirement date.  If you invest in a fund designed for 40-year olds when you were twenty, you would not be taking on enough risk to get the returns you need to grow your retirement savings early.

Instead, choose the fund appropriate for your normal retirement age.  If you save like crazy and do really well in the TDF in the first couple of decades, such that you think you’ll be able to retire within five years or less, shift to a TDF designed for someone five years from retirement at that point.  If the markets do not do well or you aren’t able to save like you think and you end up not having enough to retire at age 45 like you planned, you might just need to work another five or ten years.  Eventually, there will be a good streak in the stock market that will raise your returns.  If you invest too conservatively early, you’ll virtually guarantee that you will have sub-par returns and need to work that much harder to meet your goals.

Why not supplement your TDF investments with other funds?

You might be tempted to add a bond fund, small-cap fund, or specialty fund to your TDF to up your returns.  But remember what you’re doing – you’re using the TDF to automatically get you to your goals.  Adding other funds to your TDF would be like adding a clutch and gearshift option to your automatical transmission.  You might shift up into 4th gear when your automatic transmission was trying to shift down into 2nd.  A TDF fund is designed to work alone, so adding other funds makes things not work as designed.

Why not touch anything?

Let’s say that your coworkers or CNBC commentators start talking about how overpriced the markets are and how stocks are ready for a fall.  You might be tempted to sell your TDF and go to cash for a while.  The truth is that your coworkers and CNBC don’t know anything more about where the markets will go next year than anyone else.  Just because stocks are pricey doesn’t mean that they won’t go up more.  Just because stocks are cheap doesn’t mean that they won’t go lower.  If you sell out because you’re worried, you might miss a big rally that adds another couple of million dollars to your retirement account over time.  If you shift to all stocks because you think that the markets are ready to rally, you might go all-in right before a 40% bear-market decline.  It is better to leave things alone and let your TDF do its job.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

If You Think Investing is Gambling, You’re Doing it Wrong


 

I often hear people talk about how stock investing is gambling.  “It’s no different than Vegas when you put your money in the market,” they’ll say.  When I hear this sentiment, I know that the people I’m talking to have no idea how to invest.  They either don’t invest or use the markets as a casino, betting on red and black.  People who know how to invest understand risk and reward and use this knowledge to put the odds totally in their favor.  They know they will make money and can estimate about what return they’ll get, the only uncertainty is their rate-of-return during any given short time period.

It is true that if I were to put $1000 into XYZ stock and plan to sell within a year, I would be gambling.  I’ve spent over 30 years in the markets and I have no earthly idea what any individual stock will do during the next year.  I don’t even know what the markets in general will do, which is easier to predict because the action of no one person will move a whole market, but a single company can be moved by the actions of their CEO or even a single line employee.  But I can pick out a set of ten stocks and be fairly certain that I’ll make somewhere in the range of 10-15% annualized if I hold them for 10-20 years, only selling if something about the company drastically changes or a single position gets too big.  If you’d like to find out more details on how this is done and why it works, check out my book, The SmallIvy Book of Investing.  

Hey – if you like The Small Investor, help keep it going.  Buy a copy of the SmallIvy Book of Investing: Book1: Investing to Grow Wealthy or just click on one of the product links below, then browse and buy something you need from Amazon’s huge collection.  The Small Investor will make a small commission each time you buy a product through one of our links.

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It would also be gambling to buy a mutual fund or even a set of mutual funds using money that you need at the end of the year.  For example, if you were planning to retire next year and decided to put your life savings into the Investment Company of America Class A fund with hopes of doubling it so that you could go live on the beach, you would be gambling.  You would just as likely be down 30% as be up 30% next year.  Most likely you would have between 90% and 110% of the amount you invested when the year ends.  No one can predict where the markets will go over a short period of time.  To take a position thinking that you can is gambling.

You see, as long as everyone is trading with the same information, which is largely the case since financial news gets distributed so quickly and insider trading is illegal (but still does happen, and is legal for members of Congress – go figure), everything known is already priced into the price of stocks in the markets.  If it is expected to be a cold winter, the shares of companies that sell coats and heating oil have already risen.  If a tsunami were to wash over Florida and wipe out Disney World, the shares of Disney would have already fallen by the time you heard the news.  If you think that stocks are overpriced, so do a lot of other people and they have already adjusted the prices accordingly.  

 

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Because stocks are already priced to include everything already out there already, where they go next over the next week or the next year is all a matter of chance.  Maybe someone in one of the company labs will find a cure for cancer and the shares will shoot up 1000%.  Maybe the CEO will get indicted and the shares will fall 50%.  Maybe someone who owns 30% of the company will decide to throw a big party for his daughter’s wedding and sell half of his stake, causing the price to dip.  Maybe some people will just see that the price of the stock has gone up and buy more, figuring that the price will go up further.  With all of these individuals making independent decisions in the marketplace, what the stock price will do next is anybody’s guess.

So if it is all random, how can you put the odds in your favor?  You do so by looking at the past and finding the things that were true then and will likely be true in the future.  While I cannot predict whether the market will be higher this year or lower, I do know that the market is up about three years for every one that it is down.  This means that if I hold stocks for 20 years, I will probably have somewhere around 15 up years and four down.  I can also see that the returns for long periods of time (20 years or more) average around 10% before inflation.  I, therefore, know that if I hold stocks for long periods of time, while I don’t know what will happen and when it will happen, I can be fairly certain that I’ll make about 10% annualized per year before inflation.

So, if I buy a mutual fund and hold it for a year, then shift to another one or pull money out of the market, I’ll be gambling and the odds will be about 50-50 that I will make money in any given year.  This means that I’ll probably break even over long periods of time.  If I include trading fees, taxes, and the fees that the fund charges, I’ll be slowly losing money over time.  This would be like playing baccarat in a casino.  If I hold for a long period of time and don’t mess with things, the odds are very strongly in my favor (like 99 out of 100 or more) that I’ll make money, and I’ll probably make around 10% annualized.  This means that my money will double, on average, about every seven years.  It’s not like putting money into a bank CD, but it sure isn’t gambling.

So, are you investing, or are you gambling?

 

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Basics of Investing: What is a Stock?


Before we get into mutual funds and other topics, let’s start with the very basics and talk about what a stock is and why you should be interested in buying shares of stock.  Shares of stocks are just what the name implies – they are a portion of ownership in a company.  If you own 1 share of GE, you are a partial owner of GE, meaning that you get a share of the profits they make, you get a partial say in how the company is run and what they do, and if they are ever bought by another company, you would get a share of the money when GE was sold.

The term, “shares of stock,” is used to indicate the amount of ownership, where the term, “stock,” is often used by itself when referring to the shares of stock for a particular company.  For example, you might talk about the “stock” of Apple going up in price, meaning the shares of stock for the whole company are selling for more money.  You might also talk about your “stocks,” referring to the shares of the different companies in which you have ownership.  You would say that you have “100 shares of Apple” if someone asked you about your ownership in Apple.  You would say that Apple was one of the “stocks” that you owned.

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Why would you want to own shares of stock?  Well, one of the easiest ways to become wealthy is to run a business.  This is because, when you own a business, your potential income is not limited by the salary that someone else is willing to pay you.  If you add customers, add locations, and add employees, you can increase the amount the business makes.  If the business makes more money, you as the owner, make more money.  You can either take a larger amount of the income that the business is making home with you or you can sell part or all of the business to someone else for more money since the business is making a larger profit.

For example, if a pizza restaurant you own is making a profit of $100,000 per year, you could take up to $100,000 home with you, investing the amount you don’t want to take home back into the business.  If you double sales and now make a profit of $200,000 per year, you could take up to $200,000 home.  If someone wanted to buy the business after you had increased the sales, they would also be willing to pay you more than they would have before the increase since they could make $200,000 per year instead of only $100,000 if they owned the business.

Many people don’t want to go through the hassle of owning a business.  It means you need to deal with suppliers, find customers, deal with employees, worry about you building and equipment, and worry about all of the business and tax paperwork.  Perhaps you want to work at a bank or in a middle-management job at a company where someone else worries about all of these things and you just get a paycheck.  Yet you still want to be able to increase your income.  Eventually, you want to get to the point where you don’t need to work anymore, instead just having money come to you like it would if you owned a business and had other people running it so that you could lie on the beach and collect the profits.

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Owning shares of stock allows you to do this.  You buy a partial interest in the company by purchasing shares of stocks.  You can thereby be a partial owner, getting a share of the profits, but not need to run the company.  Instead, the corporation hires managers who take care of the day-to-day details of running the company for you.  All you need to do is find companies that have good teams of managers and invest your money there.  (Theoretically you could also buy a company with bad managers and vote out those bad managers, but that is almost impossible with the way things are set up.  It is better to just sell your shares and go somewhere else where they managers are good if you don’t like the management team.)

You can buy a very small percentage of the company by only purchasing a few of the shares that have been issued, or you can buy a big portion of the company by buying lots of shares.  The number of shares you own divided by the total number of shares out there shows what percentage of the company you own.  Most of the time you’ll only own a very small portion of a company, but you’ll still be able to receive a return from the business, assuming it is profitable and able to grow, eventually sending you a portion of the profits the company makes a few times per year in a payment called a dividend.

So there you have it:  What a stock is and why you want to become a stock investor.  It gives you the ability to generate income like a business owner does without actually needing to open and run a business.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.