Building A Better Investing Portfolio: Keep It Simple

The topic of investing can be intimidating and confusing for those who haven’t done much research on the topic.  When you first start looking into it people will start throwing out terms like 401(k)s, Roth IRAs, tax advantaged versus taxable accounts, index funds and so on.  There’s a lot to know, and a lot to get confused about.

Thankfully, it doesn’t have to be all that confusing, there are plenty of simple ways to invest, for even the most un-prepared novice.  Today I would like to look at building a better investing portofolio by keeping things simple.

Tips For Investing That Can Help You To Beat The Pros

The stock market and investing can be pretty complex topics if you let them be, but these days just about anyone can invest like a pro, and usually beat the returns of actively managed mutual funds.

So what are some key themes when investing – what are some things to keep in mind? I like to look to John Bogle, founder of Vanguard Group, and his 8 rules of investing:

• Select low-cost index funds: Index funds are a great way to diversify your holdings, and protect yourself against any one asset dropping in value. The index fund matches the market, and the returns you get usually outpace professional fund managers.
• Consider carefully the added costs of advice:  Be careful of paying extra for advice you don’t need.  Often people will pay for professionally managed mutual funds, or for high priced investment advisors, when in reality they could match or exceed the returns themselves through passive index fund investing.
• Do not overrate past fund performance: Too many people make the mistake of buying mutual funds that have done well in the past. Unfortunately past results don’t equal future results.
• Use past performance to determine consistency and risk
  
• Beware of stars (as in, star mutual fund managers): Beware of investing in products pitched by stars, usually you’re going to be paying through the nose for their expertise, and their extra fees can help short circuit your gains.
  
• Beware of asset size
• Don’t own too many funds: Keep things simple when it comes to your investment portfolio.  Don’t buy a bunch of funds that you don’t understand. Buy 2-3 funds that will give you broad diversification.
• Buy your fund portfolio – and hold it:  Buy and hold your portfolio for the long term, don’t pay too much attention to short term returns.

For me the best way to go when investing is to not try outsmart yourself and think that you can pick the winners and losers, because you probably can’t.  Keep it simple, buy the market through index funds, and hold it for the long term.

Here’s a discussion we had on the Money Mastermind Show about building a better portfolio.

What Are Index Funds?

Index funds are typically the main asset I would recommend people invest in.  So what is an index fund? From Wikipedia:

An index fund (also index tracker) is an investment fund (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.  As of 2013, index funds made up 18.4% of equity mutual fund assets in the US.

Index funds are basically big baskets of stocks that mirror a particular market, which can be hundreds of different company stocks, depending on which market you’re looking at. For example, the S&P 500 will be an index of the 500 largest companies based on market capitalization.

If you were to invest in an S&P 500 index fund you would essentially be buying a piece of those 500 stocks, and be diversified across the entire market.

Why Are Index Funds The Way To Invest?

Why do I suggest investing in index fund? Index funds consistently outperform actively managed funds.

In 2013, in the Journal of Indexes, Alex Benke, CFP® and  Rick Ferri, CFA found that all-index fund portfolios outperformed active ones almost 83% of the time.

The authors created a basic 60-40 portfolio with three of the most commonly held asset classes: 40% in a broad U.S. equity fund, 20% in a broad international equity fund, and 40% in a U.S. investment-grade bond fund. They then compared this all-index portfolio to 5,000 portfolios of randomly selected, comparable actively managed funds over a 16-year period (1997 to 2012). The all index-fund portfolio outperformed the active ones 82.9% of the time during the 16-year period.

Index funds beat their actively managed counterparts almost 83% of the time.  Yes, you can likely find mutual funds that beat the market in a given year, but most tend not to be able to do that year in and year out. Add to that the fact that actively managed mutual funds tend to have substantially higher fees and expense ratios tied to them, and you’re bound to come out ahead when investing in index funds.

How To Build Your Index Fund Portfolio

If you’re convinced that index funds are the way to go, there are a lot of ways that you can build a good index portfolio with little or no cost. Let’s take a look at a couple of my favorite options.

Buy Index Funds Via A Low Cost Company Like Vanguard

My favorite way to invest is in an IRA or Roth IRA via a low cost mutual fund company like Vanguard.  Vanguard is among the lowest cost mutual fund companies out there, and it’s where I prefer to invest.   So what exactly should you invest in with Vanguard?  My favorite way to invest is to invest in a 3 fund portfolio where you just buy the entire market in the fundamental asset classes, stocks and bonds. So for a 3 fund portfolio, you could buy something like this:

• Domestic stocks: Vanguard Total Stock Market Index Fund (VTSMX)
• International stocks: Vanguard Total International Stock Index Fund (VGTSX)
• Bonds: Vanguard Total Bond Market Fund (VBMFX)

Right there on one fell swoop you’ve covered yourself and bought a well diversified stock portfolio, that should get better returns than most actively managed funds.

Buy An Index Fund Portfolio Via An Automated Investment Service

If you want to have more of the investing process done for you, and you’re more of a set it and forget it type investor, you might want to consider investing your money through one of the many automated online investment services – also known more recently as “robo-advisors”.  What these companies do is invest your money for you for a low cost, usually a small annual percentage fee.  They will then invest your money for you based on your risk tolerance and preferred asset allocation. Most of them will invest for you in an index fund portfolio that is low cost, regularly rebalanced and with dividends re-invested for you. Many of them will also make sure that your account is optimized for tax purposes.

Automated Investment Services – Three of my favorite automated online investment services options are:

• Betterment:  Betterment has actually been one of my favorite financial companies for a few years now, and I have a Roth IRA with betterment.  There is no minimum amount to invest with Betterment, and the charge anywhere from a 0.15%-0.35% annual fee to invest your money in ETF index funds.
• Wealthfront: I only just discovered Wealthfront a few weeks ago, but it is quickly becoming one of my favorites for newer investors.  Like Betterment they allow you to invest in ETF index funds based on your risk tolerance, and although there is a $5000 minimum for an account, you can invest up to $15,000 for free through the link on this post.  After the first $15,000 it costs an annual fee of 0.25%.
• Axos Invest: This service is one of my favorites as they don’t charge any asset management fees for their index fund based investments, although some of their premium services like tax loss harvesting have an affordable cost.

Some other companies like Schwab have also come out with or announced low cost or free automated investing services as well. As I haven’t tested them out, however, I’m hesitant to recommend them just yet.

Things To Consider When Building & Managing Your Portfolio

When you’re building your investment portfolio, there are few things you’ll want to figure out first:

• Figure out your risk tolerance:  are you a conservative or aggressive investor?  How much risk averse are you? How far are you from retirement? If you have a higher tolerance for risk you might want to put a higher weight on the stocks.
• Figure out the best asset allocation for you: How much should you put in stocks vs. bonds in your portfolio?  It might depend upon  your risk tolerance, amount you already have saved, time horizon, and more.  With all that said, there are two ways people typically figure out their asset allocation.
  • Age in bonds:  Some investment advisors suggest putting your age in bonds. So if you’re 30 years old, put your portfolio at 30% bonds, 70% stocks. If you have a higher risk tolerance, or a longer time horizon you could consider putting more in stocks.
    
  • Twice your maximum tolerable loss: In this method you figure out what the biggest percentage loss you could bear to see in your portfolio without causing too much worry and risk of abandoning your plan. Set your stock allocation at twice your maximum tolerable loss.  So if the most you could bear to see lost is 25% of your portfolio, set your stock allocation at 50%.
• Reassessing and rebalancing your portfolio: When you’re investing in index funds, it isn’t completely set it and forget it. Over time due to gains and losses in different market sectors your asset allocation may get out of whack. Maybe your bonds become a bigger percentage of your portfolio than you’d like. Every year or so it is a good idea to rebalance your portfolio and get the assets back in line of your asset allocation. If you’re using a service like Betterment or Wealthfront, they’ll do this for you.

How To Invest If You Don’t Have A Lot Of Money

How can you start investing if you don’t have a lot of money? Here are some ideas.

• Set aside small amounts until you have enough to invest. Consider using an automatic savings account like Qapital or Dobot to help you save your first investment (Read about several microsavings sites here). Or set up automatic savings goals to a linked savings account like the ones at Ally or CapitalOne360 – which allow you to setup sub-accounts for specific savings goals.
• Start small. Invest with a company like Betterment that has no account minimums, as long as you setup automatic investments.
• Save up until you have enough to buy into an index fund you want.  Some index funds will allow you to invest with an initial investment of as little as $1000 , up to $3000 or $5000.
• Make sacrifices if you need to: Do you really need the high end cable package, or the $200 mobile phone package? Find ways to save money on all of your regular monthly bills, and invest the difference.
• Use side income to invest: Find ways to create side income, and invest your earnings after taxes!

Just Get Started Today

One of the biggest keys of investing, especially if you don’t have a ton to invest, is to get started as early as you can. The longer your time horizon for investing is, the better you’ll do, and the longer the wonders of compound interest will have to work.  If you’ve already waited to long, there’s no time to waste. Start investing today!