Investing in Mutual Funds: 101

A friend recently asked me my thoughts on mutual fund investing, seeking advice on how to build a portfolio.  Rather than just give him some notes, I choose to right a post so that anyone can see my approach.  It's certainly not perfect.  I strive for simple and easy to manage.  I do not chase the latest fad.  I talk only about mutual funds, the same thing can be accomplished with ETF's purchased through a broker, direct mutual funds save a middle man, they are easier, if you don't have a broker.  

Basic Concepts

When building a portfolio, there are several things that I think are consistently true and/or things that you need to think about:

1. Time Horizon — How long you expect an investment to grow?  What do you think the money might be used for?  Sooner and/or more critical translates to more need to protect principal which means more bonds and fewer stocks.
2. Risk Tolerance — Beyond time horizon, how do you feel about (short term) losses? Are you ok riding out a market crash like what happened in 2008-2009?   If you would feel compelled to sell stocks when they dive, you need more bonds and fewer stocks as that’s a horrible long term choice.  Conversely, if you would buy more stocks during a crash, you have a high risk tolerance (and strong stomach) and can tolerate more stocks.
   
3. Low cost beats high cost in the long run — The hot sector today will grow cold.  The ace stock picker over the last market cycle will fail in the next.  The only thing that is certain is that the more they syphon as a management fee the lower their returns will be.
   
4. Taxes reward long term capital gains — Building up capital gains is a great tax dodge.  You make more in the long run holding a broad index than hopping between the short term optimal index. This applies mostly to stocks. 
5. Income generation — If you want a cash stream, you can get it the obvious way, bonds and their dividends.  You can also use dividend stocks or just sell small some stocks to harvest cash and a few gains. It really doesn’t matter, though bond advocates will argue otherwise.
6. Talking Heads are Not Your Friend — The clowns who talk about the market are benefited by short term churn and FUD (Fear Uncertainty and Doubt).  They get paid for eyeballs or worse by buying ahead of their advice.  Don’t do anything suggested by “Mad Money” shows, in fact, consider doing the opposite. By the time their advice has hit the air waves the market has already adjusted.
7. Diversification of Investments is not Spreading Your Investments — Most funds buy the same stocks.  If you buy an large cap fund, a tech fund, and an actively managed fund, you just bought a bunch of Apple and Alphabet stock which is exactly the same in each fund.  The same applies to different fund providers.  Buying shares in funds provided by different investment firms but the same general goals gets you the same underlying investments with more people to pay.
8. Larger Amounts Equal Discounts — Many funds are available in lower cost flavors for higher balances.  Vanguard offers “Investor” and “Admiral” flavors of the same fund.  They hold the same investments, but Admiral funds have lower costs and higher minimums.  Other fund providers do similar things.  

Portfolio Building Blocks

Now into the building blocks of a portfolio.  There are a couple of larger groups of investment types.  In today’s world you balance, primarily between: Stocks & Bonds and between Domestic and Foreign.  I believe these categories are essential to any medium ($20K or more) or larger portfolio.

You can also delve into Large Cap vs Small Cap, Short Term Bonds vs Long Term Bonds, Established vs Emerging markets.  Unless the portfolio is large and actively managed, I think these differences are mostly important to avoid being wildly unbalanced.  It’s easy to screw this up than to get it right.  

To me, the building blocks of a portfolio (and an example of each, ticker symbol, morningstar rating and expense ratio) are going to be:

• US Stock Market Index (Vanguard Total Stock Market Index, VTSMX, ★★★★☆, 0.15%)
• International Stock Market Index (Vanguard Total Intl Stock Idx, VGTSX, ★★★☆☆, 0.17%)
• US Bond Market Index (Vanguard Total Bond Mkt Idx, VBMFX, ★★★☆☆, 0.15%)
• International Bond Market Index (Vanguard Total Intl Bond, VTIBX, ★★★★☆, 0.15%)

The examples are not glamorous.  They cover their sectors and provide stability at low cost making them winners in my book.

You can also use blended fund, one that attempts to cover multiple sectors in an automated way.  Some are called “balanced” funds and hold stocks and bonds in some more or less predictable way.  Some of the best of the best of this type are Vanguard’s Target Retirement series.  Those funds hold shares (with no additional cost) in the four building block funds I gave above.  The adjust to more conservative weightings (more bonds) as they approach their target date.  These are really good one fund portfolios.  

The downside to Vanguard’s Target funds is a higher cost than the constituent funds in the admiral flavor.  If the portfolio is large enough to qualify for Admiral class, those are the better choice.  Here is an article from Forbes on this: The Trouble With Target Funds.  Here is a link from the Motley Fool about this fund type: Why Vanguard Target Date Funds Are the Best in the Business.

Admiral shares of the basic index funds have a rather low minimum, $10,000 for Total Stock and an microscopic expense ratio of 0.04%!    Total International Bond Admiral also has a $10,000 minimum and a lower expense ratio of 0.12%.  The admiral shares will beat the Target Retirement funds built from the same components by a small but significant amount in the long run.  If a portfolio can qualify for only one admiral fund, it will be US Stock, which is the biggest bang and makes a direct portfolio better.

Investment Allocation

The biggest choice, in my mind is how much to put into each of the component funds.  The general rule of thumb is more stocks for longer time frames and higher risk tolerance.  US ve International is tougher but 2 to 1 isn’t far from the mark.  International seems positioned to beat the US in the next 5 years, so perhaps a bit more.

There are some handy tools for coming up with fund weights, I suggest Vanguard’s reading there How to Invest web page and follow the interesting links, this is available to everyone.  If you have an account with Vanguard, the Portfolio Watch page is very useful for some basic analysis and a good tool to set target allocations.

Larger portfolios, perhaps over $100,000 can benefit from a bit more specialization.  This isn’t necessary, but can be helpful and it “feels” more like investing than the basic fund allocation. Perhaps a healthcare index with no more than 5% of the funds.  Healthcare currently makes an attractive choice because of the meta trend of an aging population.  Another choice would be energy which is largely beaten down at this point and likely to rebound.  Doing this implies more active management and a future need to sell when the over weight is no longer appropriate.  This is by no means necessary to a solid portfolio.

Closing Thoughts

One final point, be sure to consider how investment firms make their money.  If they make money on commissions, they will be benefited by churning a portfolio.  Investment firms are in the business of making their shareholders money.  That money has to come from their shareholders in one manner or another.  One of the advantages of Vanguard is that they are owned by the their fund investors.  They don’t have separate shareholders who funnel profits from their investment products.   

One last thing, I am a total amateur at investing.  I am just sharing my thoughts.  Don't let them be a substitute for your decision making,