How should I set up my portfolio?

There are a bewildering range of choices when it comes to picking investments, so I’ll try to lay out a rational, noncontroversial investment plan. William Bernstein’s The Four Pillars of Investing recommends investing in funds that are no-load, low-cost, and low-maintenance… rather than in individual stocks or those funds that are actively managed funds.

He argues against actively managed funds because fund managers charge fees but often don’t even deliver better results than the broad market. Mutual fund managers are outrageously overpaid since their compensation is a function of the total money they manage – a manager of a $1B fund with a 1% management fee pays himself $10M a year even though he probably stinks at picking stocks. The modern financial industry is one of the greatest value-destroying operations in human history.

A mutual fund that charges 1% in management fees must outperform the market by more than 1% to just break even with the market, while a fund that charges 2% in management fees must outperform the market by more than 2% to do the same, and a fund that charges 3% in management fees must outperform the market by almost 3.5%! Outrageous! Since we are talking about growth rates that average 10% a year, each percentage point really eats into the money you make. The interests of stockbrokers and mutual fund managers are not aligned with your own. Stockbrokers and fund managers have an old saying: “My job is to slowly transfer the client’s assets to my own name.” Moreover, even if a fund manager has happen to beat the market last year or whenever, there is no guarantee that they will continue to outsmart the market in the future.

He argues against picking individual stocks because there is no way to effectively diversify risk away in the way that broad market funds do, and it is too hard to outsmart the market every time, or even most of the time. Even book my favorite book on stock picking, Peter Lynch’s One Up on Wall Street, teaches you to legally trade on information Wall Street doesn’t have. Even if you think you know something Wall Street doesn’t, you are still taking a large risk on whether Wall Street actually does not already know that piece of information and whether it is even an important kernel of information.

That leaves passively-managed funds. Pick funds that are:

• no-load, ie no fee associated with accumulating the fund.
• low in management fee/expense ratio, ie close to 0% of the total value of the fund goes to the fund company.
• low in annual holdings turnover. Since it costs money to for funds to buy and sell their holdings, just like your broker charges you a commission on your trades, the lower this is, the less fund assets are being funneled away to pay the fund’s stockbroker.
• devoid of other silly fees, like 12b-1 fees. (If you don’t know what 12b-1 fees are, you can easily look it up online, or just accept that it is a silly fee you need not pay.)

For a few examples of funds that fit these criteria, look at these sample portfolios.

Sample Portfolio #1: David Swenson

David Swenson is the famed manager of Yale’s huge and successful endowment. You can view his portfolio here. At current (8/27/07), this portfolio is about 30% US total market (VTSMX), 15% inflation-protected (VIPSX), 18% real estate (VGSIX), 6% emerging-markets (VEIEX), 15% developer int’l (VDMIX), and 15% bonds (VBMFX). All of these holdings are in Vanguard low-expense funds.

Sample Portfolio #2: Ben Stein

“What I generally recommend for the noncash portion of your portfolio – and this has been unbelievably successful – is a mix of various index funds and exchange-traded funds [ETFs], with roughly 25% in an S&P 500 index fund from Vanguard or Fidelity; 25% in a Vanguard or Fidelity total stock market fund; 25% in EFA, which is an ETF for developed overseas markets; 15% in EEM, an emerging-markets ETF; 5% in ICF, the ETF for real estate investment trusts; and 5% in XLE, which would be your energy fund.

“I’m not a big lover of bonds because I think the risks involved in buying long-term bonds are tremendous, and the payment from short-term bonds is trivial. That said, you should have 20% of your portfolio in cash. I would say if you can get 5% or more on your cash in a CD or savings account, go for it. That way, you have it to tide you over if you lose your job or your health worsens.” (Source)

Your Portfolio

I think the sample portfolios above are fairly good guidelines and can almost be emulated out of the box, or tweaked if you are more risk-averse or risk-inclined, particularly for a 20-something’s retirement account. Since young professionals have retirement investment horizon that are so many, many years away, they can definitely be more risk-inclined. Ways to shoot the moon include weighting more of their portfolios in relatively risky assets such as small-cap and emerging markets and less in cash and bonds.

Also, remember to diversify. Diversification means investing across various asset classes. Asset class options include domestic vs foreign, value vs growth vs S&500 vs real estate, inflation-protected securities, commodities funds, and more. The point is to put your cash in several of these asset classes to ensure that if some part of a rising market is growing more quickly than the others, some part of your portfolio is benefiting, and if some part of a falling market is falling less quickly or even growing, you’ll benefit from that too. The sample portfolios are good examples of diversification.

Another consideration is to time-diversify by commit your money in chunks spaced out over time. That way, you can ensure that you are not plunking down all your money when the market is at a peak.

Maintaining Your Portfolio

• Occasionally rebalance your portfolio. If one asset class in your portfolio has been growing extremely quickly in the last few years, consider shifting some of your gains and perhaps your future contributions to the more slowly growing parts of your portfolio. This may seem counterintuitive, but it will likely help you follow the easily-said-but-difficult-to-follow adage, “buy low, sell high.” Just be sure to avoid paying sneaky fees (like frequent trading fees that may apply to mutual funds funds – be sure to check on those).
• Keep things simple – no one wants to spend more time on managing retirement funds than they need to. Notice that the sample portfolios each pick one fund to cover an asset class. This makes the portfolio easily analyzable.

Capital Gains versus Income
This is only relevant to non-retirement accounts (since retirement accounts are happily tax sheltered). When you sell a security, if you have held that security for a year or more, the profit you make is taxed as a capital gain, which is a tax rate much lower than the income tax rate you had to pay when you previously exercised the option. Or if you have a capital loss, then you pay capital gains taxes on your net capital gain at the end of the year. The capital gains tax rate is a mere 15% and will be so through 2010 due to the Tax Reconciliation Act of 2006. The capital gains tax rate exists to encourage investors to make long-term investments and in general applies to investments you have held for one year or more.

Miscellaneous and Somewhat Academic Banter
Most index funds are market capitalization-weighted funds, which means that at the end of each day, computers calculate the market capitalization of each stock and then rebalances the funds holdings using those market caps as weights. This approach “overweights every single stock that is trading above fair value and underweights every single stock that is trading below true fair value” (Source). Academically and practically, I believe that there are certain statistical methods of indexing that are superior to market-cap weighting. I personally am on the lookout for promising-looking index funds that are weighted by other metrics (and are passively managed, of course), but even then, the 401k plans I have seen have only index funds weighted by the old-fashioned market-cap method.

If you have decided to buy stocks…
then you should have accepted the possibility that you will not even beat your index funds or that you may even lose a significant portion of your investments. Individual stocks are incredibly volatile, so you might see your stocks increase in value or see their value wiped out in the time it takes you to finish lunch. If you really want to buy stocks, you should are prepared to do the research on each of your stock picks and to follow them closer than you follow your fantasy sports teams. I would start with Peter Lynch’s One Up On Wall Street, doing lots of research on each stock you are considering, and avoid putting blind trust in the financial press. The Motley Fool and Jim Cramer and the more info-pornographic finance articles of BusinessWeek are written to sell subscriptions, not real stock advice. In the words of someone I respect, “the financial business press generates a continuous hype cycle rife with survivor bias and other forms of retrospective distortion.”

Just compare Warren Buffett and Jim Cramer. Cramer gives a few stock picks per weekday show and then gives dozens more buy and sell calls on the Lightning Round each week. On the other extreme, Warren Buffett has often said that he can only find a few good investment ideas per year. Granted, Buffett often buys whole companies when he picks a stock, but his approach is similar to Peter Lynch’s, and if you are going to pick stocks, you should emulate these quiet masters rather than follow these blustering financial journalists.