Investing Advice for the Masses

The past two days I have outlined and analyzed strategies for individual investing. In the posts, however, I have alluded to the fact that I don't think either of those strategies are relevant or smart for the large majority of individuals. So what strategy does make the most sense for the largest segment of the population? We're going to explore it in this post.

Investing Philosophy

Matching the market is incredibly easy, while beating the market is incredibly difficult. It's that logic that guides my principles to individual investing - a simple, well-balanced, appropriately allocated mixture of funds that allow for long-term growth when dollar-cost averaging into the funds over a significant period of time. Another saying that implies the same thing is "Keep It Simple Stupid" or the KISS principle. For most people, keeping it simple will optimize returns and will allow you to better understand your investments, which is vital for any individual. These practices are espoused by financial planners and have proven time-and-time again to be effective at beating most Wall Street types as well as portfolio and fund managers. That is because of the fees associated with increased complexities in investment choices.

One doesn't need to financial adviser to make sound investment choices - in fact, his or her fees just eat into your gains. If it makes you feel more comfortable with your assets to meet with an adviser, there is certainly nothing wrong with it. Just make sure they are fee/hourly only and not on commission (those on commission are more like salespeople who try to sell you investments such as variable annuities that most likely you do not want).

Where to Invest

Ok, so let's get down to it. How can you be diversified and match or beat most Wall Street investors after fees are taken into account? Low-cost index funds.

Besides the investment objective and holdings, the net expense ratio is the most important aspect of a mutual fund. Vanguard is especially known for its offerings of great, low-cost options. Charles
Schwab (which recently reduced its ratios to rival Vanguard and has lower minimums, as low as $100, if you don't have much to invest) and Fidelity are other good choices. You shouldn't pay more than 0.25% for index funds.

Passively managed index funds beat 60-70% of actively managed funds on a yearly basis after expenses are taken into account. Sure, you could be lucky and choose one of the 30-40% of active funds that beat the market in a particular year, but that fund typically then
underperforms the market the next year. There's no way to know - historically, it has been irrefutably demonstrated that staying in index funds over the long-term increases the likelihood of maximum returns. In fact, over a ten year period, a full 95% of actively managed funds trail market averages after taking expenses and taxes into account. Thus, sticking with high quality, low-cost passively managed index funds over the long-term is clearly the way to go to maximize returns.  Pick up and read Will McClatchy's Strategies for Investment Success: Index Funds if you want this beaten into your head and a plethora of data supporting this claim.

Another problem most people have in their portfolios (both retirement and normal) is that they have redundant and repetitive funds or "closet-index funds." Both are bad things to have. I know many individuals have twenty or so funds, and many of them are nearly identical with the same objective and very similar holdings. (Side note: avoid front-end and deferred loads at all costs). Trim the fat! Invest in only the lowest cost fund. "Closet-index funds" are funds that advertise as actively managed funds (and charge near 1.0%), but when you dissect its holdings, it is essentially an index fund. Those should be avoided like the plague.

Now that we have a basis for understanding the philosophy and logic behind
simple, dollar-cost averaged low-cost index fund investing for the long-term, we can give a more detailed layout of what your holdings might look like. The allocations of stock to bonds obviously shift as you age, so that should be taken into consideration.

You do not need 30 mutual funds to get invested in every sector in the market and every asset class without redundancy. In fact, I'd argue that it's actually more difficult to be diversified with that many funds.   Money Magazine's Michael Sivy, Carla Fried, Carolyn Bigda and George Mannes, wrote a nice article, which I will summarize. Here are the only seven investments you really need according to them:

  1. US Index Fund - Choosing a low-cost blue-chip US Index fund should be the staple of any investor. International holdings (especially Latin America, Eastern Europe and other emerging markets) have been the rage over the past 10 years (although they were obliterated last year), but historically US firms are the bread and butter and account for a significant portion of the world's economic equity value. US stocks have have grown eightfold after taking inflation into account since 1908, while gold has only doubled. Recommended funds (symbol; net expense ratio): Vanguard Total Stock Market Index (VTSMX; 0.18%), Vanguard 500 Index (VFINX; 0.18%), Schwab S&P 500 (SWPIX; 0.09%), and Fidelity Spartan 500 Index (FSMKX; 0.10%)
  2. Foreign Stock Index Fund - Most of the growth and economic activity comes from outside the US. In order to be truly invested in this global market, you need an international index fund. On top of that, having foreign investments increases diversification. US and foreign markets aren't always in lockstep direction, so having a piece of both developed and emerging markets outside the US is key to true diversification.
    Recommended funds
    (symbol; net expense ratio): Vanguard Total International Stock Market Index (VGTSX; 0.34%) and Schwab International Index Inv (SWINX; 0.19%).
  3. Small-Cap Fund - In order to capture the growth companies and "the next Microsoft" you need to have some money allocated to a small company fund. These have historically outperformed large-cap stocks, but you must realize that there is increased risk involved. The greater the risk, the greater the reward. It also gives you extra diversification. Check out NAESX.
  4. Value Fund - Similar to small-caps, value funds have outperformed large-blends over long time periods. These stocks also typically pay higher dividends and are purchased for "discounted" prices. Check out VIVAX.
  5. All-Encompassing Bond Fund - Stocks will be the majority of your portfolio for most of your life, but bonds are necessary to reduce risk and increase diversification at all times. The income is more reliable and they have still returned around 7% since 1998 (beating stocks). Rather than choosing a short- or long-term approach to bonds, it's easiest to just invest in a total bond fund such as VBMFX. Hold bonds in retirement accounts, if at all possible, due to the tax ramifications. Your stock portion should be in taxable accounts and the spillover (hopefully, it's significant) should be in retirement accounts.
  6. Inflation-Protected Bond Fund - Inflation destroys purchasing power. Averaging about 3% annually, inflation can take a big chunk out of your investment gains if you don't play it properly. To counteract the effects of inflation, it's wise to put some money in TIPS (Treasury Inflation-Protected Securities). Check out VIPSX.
  7. Money market fund - It's essentially a cash account, but there are times when you need to take advantage of buying opportunities or have extra emergency cash available. Certainly, it makes sense for this to be a small part of your portfolio.
So, that's it! If you have more than that, you might have redundant holdings and should consolidate the funds.  I'd note that having a Small (3) and Value (4) fund isn't entirely necessary in my mind.  I'd encourage the use of a single Small Value fund, like VISVX, as reported in my Lazy Portfolios post, but you could just as easily have neither.  If you're early in your career, you also don't necessarily need a TIPS fund as your salary increase should correspond with inflation somewhat.  And some prefer using savings accounts to money market funds.  Thus, there are really only three funds you absolutely need - a US equities, international stock, and a bond fund.

If your 401(k) provider doesn't necessarily provide the exact replica (mine, for example, doesn't give a TIPS fund as an option), but you should do your best to find suitable replacements or purchase it in an IRA. Dollar-cost average into these funds over the long-term and you will be on your way to outpacing the majority of the public because of your reduced fees and simple approach. I'd also encourage investors to look into holding an REIT fund in retirement accounts, such as Vanguard REIT Index (VGSIX; 0.26%). For why REITs make sense in retirement accounts, see this post.  I wouldn't find it outrageous, however, to not hold an REIT fund as you're already holding REITs in market weight with a total market fund (and Small Value funds also hold a larger percentage of REITs traditionally).  

Simplifying Your Portfolio

Allan Roth agrees that only the three funds I mentioned above are
really necessary to be truly diversified:

  • Vanguard Total Stock Market Index (VTSMX)
  • Vanguard Total International Stock Index (VGTSX)
  • Vanguard Total Bond Market Index (VBMFX)
The return of the three-fund approach vs. the seven-fund approach is negligible and the increased simplicity as well as reduction in re-balancing (easier to re-balance three funds as opposed to seven; you should re-balance once a quarter), might make it worth it in some circumstances.

In an article linked on his website, he shows how his second grade son took on Wall Street with this simple approach.

I'll take it even one step further and suggest how you can be truly diversified using
one fund from the options in Vanguard's LifeStrategy or Target Retirement Funds. Yes, that's right - just one fund that won't require any re-balancing. I'm not personally a fan of how target retirement funds adjust their allocation as you age (just ask those who were planning to retire in five years and invested in the Target Retirement 2015, which was down nearly 30% last year), but I do find them as great tools to diversify with less capital. For a simple all-in-one portfolio, you could certainly do much worse than these funds, especially if you don't have much to invest. For example, if you wanted the Total Bond Market to be only 10% of your total portfolio, you'd need $30,000 in assets to invest to get the appropriate allocation by using single-purpose funds (since Vanguard typically imposes a minimum of $3,000 per fund). By the way, you should consider all your accounts (taxable, 401k, IRA, etc.) as a single entity when determining and evaluating your overall asset allocation. To get around the minimum and/or simplify your portfolio's holdings and re-balancing, you could simply invest in Target Retirement 2050 (VFIFX), which in turn invests in the total stock market, total bond market (at 10% of its total holdings), and total international equities. All in one fund!

LifeStrategy funds have a similar principle in that they invest in a variety of Vanguard index funds with a single fund. It's really a great option if you can't handle keeping track of more than that. An aggressive allocation goes something like 70% Total Stock, 20% Total International, and 10% Total Bond. A moderate allocation is 40%, 20%, and 40%, respectively. While a very low-risk, income generating allocation is around 20%, 10%, and 70%, respectively. However, LifeStrategy funds are not ideal choices for taxable accounts due to the tax inefficiencies as I outlined in my first Q&A; they hold the Vanguard Asset Allocation Fund, which adjusts its allocation and thus realizes capital gains. Therefore, the Target Retirement funds are preferable for taxable accounts (ignore the year and simply examine the stock/bond percentages that match your desired allocation).

As I previously alluded to, if you want to practice tax-efficient investing (as you probably should), these all-in-one fund solutions might not be the ideal choice (although the simplicity of such funds might be worth it). Bond funds and REITs are more tax inefficient than stock funds and are thus best held in tax-advantaged accounts, while the stock portion should be in your taxable accounts. For principles of tax efficient fund placement, see this article.

For a discussion of eight pre-screened portfolios using the low-cost index fund approach, see my article on Lazy Portfolios. The portfolios vary from 3 funds to 11 funds and offer investors a great resource for do-it-yourself portfolios. You can slice and dice funds as you see you fit based on your own personal circumstances or keep a more simplified approach.

Analysis of Portfolios

Morningstar's free X-Ray tool is a great way to analyze your portfolio holdings. Using an allocation of 70%/20%/10% with the three funds vs. 100% in the Vanguard Target Retirement 2050, you can see the similarities and negligible difference from a composition standpoint (note that tax ramifications should still be considered, however).

(click to enlarge)

Source: Morningstar, Inc.

They are nearly identical! If I did the same assessment with the seven funds, I'm certain is would be very similar as well. Note also that the expense ratios are both below 0.2%, while
Morningstar indicates that a similar hypothetically weighted portfolio typically costs around 1.2%. One percent may not sound like a significant difference, but with the power of compounding over the course of several years, that really adds up! So, not only have we simplified the investing approach to fewer than seven funds, we've reduced expenses, redundancy, and increased your potential for better returns!

Here is the analysis with all seven funds with the following aggressive, early in career allocation: 60% US Blue-Chip, 20% Total International, 5% Value Index, 5% Small-Cap Index, 7.5% Total Bond, and 2.5% Inflation-Protected Securities.

(click to enlarge)
Source: Morningstar, Inc.

Notice the similarity. It is
very slightly more skewed towards value (37% vs. 34% for other two portfolios) and large-cap (again, 3% difference). But, in the end, there is little difference and the performance of all three strategies will be quite similar. If you have enough funds wherein it makes sense to more broadly diversify across several non-redundant funds, then perhaps it is logical to use them all. Otherwise, don't sweat it and use the three- or one-fund approach without looking back.


In the end, remember that it's
incredibly simple to match market returns and be truly diversified as long as you pick appropriate funds that you understand. Although this may be a "boring" approach, it has proven to be effective and out-performs the majority of investors who attempt to pick hot funds, stocks, time the market, and use other trading or investing techniques. If you have the time, knowledge, and interest in picking individual stocks or investing in other asset classes, then there's certainly nothing wrong with doing that with a small portion of your total portfolio - say 5-10%. But even in those cases, the vast majority of the portfolio should encompass the aforementioned boring approach.

For the
majority of investors, this simple approach is by far the best option. It's not even close.
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