How to Build an Investment Portfolio
Posted Apr 01, 2008 | 0 Comments
tags: dfa,
fidelity,
how-to,
index funds,
investing,
vanguard
It irks me every time I see an ad for some pompous investment advisory firm. It typically shows some well-to-do people sitting around smiling, while a generic acoustic guitar strums in the background, and some guy with a gruff voice tells you how good they are at managing their client’s “complex” investment objectives. I think we all have one simple objective – to make as much money as possible! It should come as no surprise that these companies are incredibly wealthy because they often make more from your money than you do. The truth is, it’s easy to invest your money all by yourself with the simple advice in this article and beat the vast majority of investors using high-cost brokerage firms.
“The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.” — William Bernstein
I know I’d feel duped if I realized I was contributing part of my earnings to the $2.65 million per year needed to keep naming rights for the Edward Jones Dome. More typically, your assets will be siphoned off to silently fund a marketing campaign and provide a salary for the guy who sold you your funds. This isn’t conspiracy theory, it’s literal truth. Take a moment to read about loads and 12b1 fees if you aren’t familiar with these terms. Of course, some people get a thrill from throwing their money around indiscriminately and don’t care if they’re paying their advisor more than they’re paying themselves. My opinion is these people need to be taxed at a rate of 100% until they come back to reality.
Indexing vs. Active Management
The history of the stock market is a random but upward coarse over time, as illustrated in this graph. Research has consistently shown that expensive, actively managed funds are most likely to fall behind of the overall market’s return. Interestingly, these funds dominate most portfolios, and are invariably what financial advisors will try to sell you. Meanwhile, index funds, by definition, are designed to track the market, and while they rarely if ever beat the market, they almost always match it. Considering a historical annual return of ~10%, the market’s performance is something anyone should be happy with. So what is an index fund? And why does active management have such a poor track record? Let me explain these things briefly…
An index fund is a mutual fund designed to track some market index, which can be broad such as the Wilshire 5000 index that tracks the entire US stock market, or more narrow such as the Russell 2000 Value index that follows US small-cap value stocks. The stock make-up of a true index is determined by an objective algorithm, rather than an emotional human, leading to optimal diversification, low turnover and resultant low costs. Costs are important because investing isn’t free. You want to pay as little as possible, meanwhile financial companies want to sneak in as many fees and hidden expenses as possible. An interesting fact is that the only quality of a fund that has been shown to correlate consistently with higher returns is lower costs, as illustrated in the table below. If you use an indexing investment strategy, you will lower costs drastically. Financial advisors hate index funds because they don’t make any money from selling them.
| Expense Ratio | Average Annual Total Return |
|---|---|
| 0.50% and below | 12.05% |
| 0.51%-1.00% | 11.67% |
| 1.01%-1.50% | 11.23% |
| 1.51% and above | 9.16% |
| Note: Data are for ten years ending Dec. 31st 2004 (Source: Lipper Inc.) | |
Active management means there is a fund manager who picks stocks for the fund based on their opinion of what will do best. More often than not, this results in overactive buying and selling, substantially increasing costs and attenuating gains. To worsen matters, managers tend to pick stocks based on their predictions of where the market is headed, rather than analyzing the value of individual companies relative to their stock price (a successful stock picking strategy called “value investing”). Trouble is, no one can consistently predict the future of the market, which besides its upward trend, is random.
Now, a brief history of actively managed mutual funds: if you go back to 1970, there were 355 of them in existence. Only nine beat the S&P 500 (a common index of the US economy) through 1999, and only two of them by more than three percent. That’s a pretty poor record – two out of 355. Bottomline: picking a winning actively managed fund is very much like playing the lottery or going to a casino – the odds are stacked heavily against you. If that sounds like a good way to invest your retirement money, have fun. With indexing, your investments will mirror the market and closely follow its long-term upward trend.
Asset Allocation and Portfolio Theory
With index funds you always get the lowest costs and market tying performance, leaving just one factor to be concerned with: asset allocation. Asset allocation means having an appropriate amount of money invested among the various asset classes and “styles” of US and international stocks, bonds, and treasuries, so that you “don’t put all your eggs in one basket”. A general principal is that riskier investments are more volatile and have the potential for amazing gains but also devastating losses. Stocks, or equities, are a risky investment class, and some stocks are much riskier than others. Nevertheless, in the long-run, they are by far the highest-performing investments, and so they appropriately make up the bulk of any portfolio with a distant time horizon.
You can leverage risk or volatility by combining investments that have a poor or negative correlation with each other, so that while one is moving down, the other is typically moving up. Commonly this involves adding some proportion of bonds and treasuries, which generate steady positive interest while buffering the wild swings of the stock market. In the end, a well-balanced “portfolio” achieves greater long-term returns with less volatility than one made up of stocks alone. How you decide to balance your portfolio should be based on a realistic assessment of your risk tolerance.
The remainder of this article will look at three sample asset allocation strategies that you can copy, alter, mix and match. I’ll start by looking at a simple, single fund approach and end with a portfolio made up of fifteen different index funds. Among these examples, I think you’ll find something that’s just right for you.
Target Retirement Funds
Fidelity Freedom 2045 Fund
Portfolio management can be as simple or complicated as you like, but if you’d rather be completely hands-off with your investments, everything can be managed for you automatically. One way of doing this is to pay an advisor to help you set up an asset allocation and periodically move things around to keep it balanced and appropriate, and they will be happy to lop an additional 1-2% off in addition to the actual fund expenses for this service.
Today, most of the major mutual fund companies have introduced target retirement funds that do this formulaic work at no additional charge. These funds are named by a year that should be close to your target retirement date. The asset allocation automatically adjusts to be more conservative as you age, basically meaning it will very gradually shift from stocks towards fixed-income like bonds and treasuries.
Most of these are actually conglomerates of actively managed funds, like the Fidelity Freedom Fund shown to the right. This is a downside for the reasons I already mentioned, including higher costs. With expense ratios in the range of 0.75-1%, this means that each year, regardless of gain or loss, that percentage of your money will go to the brokerage firm, paying the costs of active management.
Vanguard Target Retirement 2045 Fund
Vanguard’s target retirement funds are the exception, composed of index funds, with expense ratios of around 0.2%, making them the best option in my book. Again, why hold any active funds when they have such a poor track record? All of these retirement funds have merit though, given the convenience of having a robust portfolio contained within in a single fund that adjusts its asset allocation automatically for your whole life.
Total Market Index Investing
If you’d like a bit more flexibility and control over your portfolio, you can follow another simple strategy using total market index funds. The Bogleheads’ Guide to Investing suggests the following asset allocations based on your age, using Vanguard total market index funds:
| Young | Middle-Aged | Early Retirement | Late Retirement | |
|---|---|---|---|---|
| Total Stock Market Index Fund | 80% | 45% | 30% | 20% |
| Total International Index Fund | 0% | 10% | 10% | 0% |
| Total Bond Market Index Fund | 20% | 20% | 30% | 40% |
| TIPS | 0% | 20% | 30% | 40% |
| REIT | 0% | 5% | 0% | 0% |
As its name implies, the Total Stock Market Index Fund (TSM) tracks all traded US stocks, and so, if it had existed in 1802, it would have closely follow the line labeled “stocks” in the graph shown earlier. Similarly, the Total Bond Market would follow the course of the line labeled “bonds”. And so on…
The Bogleheads’ Guide to Investing
Bonds, TIPS, and REITs
Bonds and TIPS (Treasury Inflation-Protected Securities) are included in a portfolio to decrease its overall risk. They are investments that typically have some guaranteed appreciation, albeit with less potential gain compared to stocks. Also, they have low correlation with stocks, often moving in opposite directions with market swings. Additionally, bonds and TIPS don’t correlate with each other, so having both gives you the best hedge against the more risky stock portion of your portfolio. The easiest way to own them is to buy into a low cost index fund.
REITs (Real-Estate Investment Trusts) are another asset class that doesn’t correlate much with others, adding further diversification, although at a recommended 5% in only one of the age groups in the table above, it’s obviously not a key part of the authors’ overall investment strategy. Many agree that REITs are not that important to hold, while others use them for greater than 15% of their portfolio. Esoteric discussions about REITs, TIPS, and other aspects of asset allocation theory can be found in abundance at the Diehards.org Investing forums, another product of John Bogle / Vanguard fans. They are always bubbling with interesting, intelligent discussions to give you food for thought, if nothing else.
Beating the Total Stock Market Index
While anyone should be happy with tying the market, with its average ~10% annual return over the past 80 years, some index investors use strategies to beat it over the long term. To beat the TSM, you must be willing accept greater risk and volatility in your investments.
If you are using the historical upward trend of all stocks over long periods of time as your justification for investing in them, why not focus on a defined subset of stocks that have done the best of all? You may have seen or heard of the Morningstar style box that visually categorizes stocks based on company size and relative value or growth qualities. Using these definitions, research has shown that small and value stocks have consistently outperformed the market at large, while growth stocks have lagged behind. These traits seem to act independently, meaning that stocks don’t have to be small and value to outperform, but there is a distinct value effect, as seen in large value stocks, and a small company effect, as seen in small blend or “core” stocks. That is the gist of the market-beating strategy of overweighting small and value stocks in your portfolio relative to the TSM.
The performance of small and value styles carries over to international stocks as well, as shown in the graph above. Here it looks like they beat out US stocks, but really it is just that the data started being collected in 1982, at the beginning of the 80’s bull market, after a long recession in the world economy. Increased exposure to emerging markets is another consideration, given that it is the highest overall returning asset class of all (using data collected since 1989). EM stocks have been extremely successful in the past 5 years, surpassing the S&P 500 by a huge margin. The caveat is that these higher performing asset classes have also had the most volatility, as indicated in the standard deviation values shown at the bottom of the figure above. Meanwhile, sticking to the TSM / S&P 500 gives you the least volatile equity portfolio.
IFA Index Portfolio
Vanguard TSM / Total International
A good example of a riskier asset allocation strategy is seen in the portfolios offered by Index Funds Advisors (IFA), which are heavily tilted toward small, value, and EM stocks relative to their global market capitalization, or in other words, relative to the way they would weighted in a total market index portfolio. This is shown nicely above, using Morningstar’s Instant X-ray to look at how the style box for an IFA portolio compares to one composed of Vanguard’s TSM and Total International index funds (70/30 ratio).
If you plan to stay invested for 10 years or more, a riskier indexing strategy becomes very attractive, and if history is any guide, it is likely to pay off. This is illustrated in the figure to the right, showing 10-year annual rolling period returns from 1957-2006 of five different IFA portfolios, which use DFA index funds. This impressive back-test shows the highest-risk portfolio “90” with an average annual return of almost 14 percent over 50 years, never dropping below a 5% average over any 10-year period. The table below compares the make-up of these five portfolios:
 |
 |
 |
 |
 |
|
|---|---|---|---|---|---|
| US Large Company Index | 4 | 8 | 12 | 16 | 20 |
| US Large Cap Value Index | 4 | 8 | 12 | 16 | 20 |
| US Small Company Index | 2 | 4 | 6 | 8 | 10 |
| US Small Cap Value Index | 2 | 4 | 6 | 8 | 10 |
| Real Estate Index | 2 | 4 | 6 | 8 | 10 |
| International Value Index | 2 | 4 | 6 | 8 | 10 |
| International Small Company Index | 1 | 2 | 3 | 4 | 5 |
| International Small Cap Value Index | 1 | 2 | 3 | 4 | 5 |
| Emerging Markets Index | 0.6 | 1.2 | 1.8 | 2.4 | 3 |
| Emerging Markets Value Index | 0.6 | 1.2 | 1.8 | 2.4 | 3 |
| Emerging Markets Small Cap Index | 0.8 | 1.6 | 2.4 | 3.2 | 4 |
| One-Year Fixed Income Index | 20 | 15 | 10 | 5 | 0 |
| Two-Year Global Fixed Income Index | 20 | 15 | 10 | 5 | 0 |
| Five-Year Gov’t Income Index | 20 | 15 | 10 | 5 | 0 |
| Five-Year Global Fixed Income Index | 20 | 15 | 10 | 5 | 0 |
Within the stock portion of each IFA portfolio is an identical ratio of styles and asset classes. Rather than subtracting from small, value, or EM allocations, risk is leveraged by increasing the proportion invested in fixed income indexes, which are mostly comprised of bonds and treasuries. This contrasts the Vanguard portfolios discusses earlier, where the domestic / international stock ratio varied between age groups, on account of the historical notion of foreign investments being riskier. Another difference here is that rather than just going by age, IFA provides a Risk Capacity Survey that will recommend a portfolio number based on your answers. A higher portfolio number means more risk – more stocks and less fixed income.
IFA‘s founder is the author of an index investing book (where I got some of my figures), called Index Funds: The 12-Step Program for Active Investors
Not everyone has easy access to DFA, or even Vanguard index mutual funds for that matter, so in a planned follow-up article, I will show you how you can use any brokerage account to build a robust index portfolio using index ETFs. In addition to replicating the portfolios shown in the tables of this article, I will look at other ETF portfolios advocated by various investment professionals and enthusiasts. After that, my next article will look at the best overall brokerage accounts out there, with a focus on an indexing investment strategy.
Conclusion
I hope one thing people can take away from this article is that there is no single “right” way to build a portfolio, and it doesn’t have to conform exactly to any standard. I know that for me, part of what held me back from investing earlier was thinking I would screw everything up if I didn’t do it just right. This is what leads so many people to give up and hand their money over to a broker / adviser combo person. This sets up a conflict of interest that slowly, invisibly robs millions of investors of a portion of their retirement savings.
Even if you just invest in TSM and nothing else, you will beat most of these thieving advisory firms. With a riskier index portfolio tilted toward small and value stocks, you should blow them away. The most important thing is to put your money in the market early and often, so you can take full advantage of the power of compound interest to grow it exponentially over your lifetime. Knowing there is room for flexibility makes getting your feet wet in investing a lot more comfortable, and using index funds to track the market instead of a manager’s whims also leads to greater peace of mind.
