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« It's Magic! | Main | Market Risk, Part II; Barriers to International Trade »

Okay, So Here's the Deal

Despite all of the obvious risks to the financial markets, ultimately we have to put our money somewhere, don't we?  There quite simply are no risk-free investments.  Hopefully we can find some place to invest where our money will, over time, grow.  So, where is that place?  The world of investment options, even for those of us with modest asset, is one of a bewildering array of choices.  If you have an idea for the next "big thing," then viloa, you know exactly where to put your money.  If not, then you are left, as am I, to invest in the ideas of others.  If you do have that idea, then go for it.  Grab for the brass ring; one of the quickest ways to riches, and one of the most satisfying I am told, is to start your own business.  Of course, if the business fails, it is also one of the quickest ways to go broke, Robert Kiyosaki and his Rich Dad, Poor Dad books notwithstanding.  You also have the option of placing big bets on one or two stocks and hoping they take off like Qualcomm or Apple.  If you guess wrong, like many of us have in the past, the outcome could be less than desired for your retirement account.  A safer choice would be to invest in a number of stocks, bonds, and other investment choices across a broad spectrum of the investment world.  This will increase your diversification and lower you investment risk.  Successfully investing in individual stocks and bonds takes a good bit of money to begin with, more time, and not a little bit of skill.  Of course in the process of diversifying you forego the idea of hitting an investment home run and becoming rich quickly.  There's always a trade off, isn't there? Some would suggest that investing in various types of real estate is one of the surest ways to financial success.  Years ago I proved that one can lose money with such an approach, and lately others have also learned that real estate goes both up, and down, in value.  So what approach should one with limited funds, time, and investment skills take?  Through the process of elimination I have determined that the best way for me to invest is by using mutual funds and exchange traded funds (ETFs).  ETFs are simply a basket of stocks, bonds, or other investments that usually track an index of some sort (i.e., the S&P 500)  but are not actively managed.  Their management expenses are thus quite low, usually lower than an actively managed fund, and they trade just like stocks on the various exchanges.

Over some thirty years of investing, I have made many of the mistakes and have experienced some of the successes involved with the process.  Most of the successes have come because I have simply been patient.  I do not claim to be an expert, but firmly believe that most "experts" are no better equipped to make sound investment decisions than are you or I.  My experience teaches me that the primary characteristics of successful, long-term investors are the ability to live on less than they make and the persistence to stick with an investment plan.  Successful investment plans can take a variety of shapes.  Let me share with you a couple of the forms they may take.

 One of my favorite financial columnists is Scott Burns, who writes for the Dallas Morning News.  Some years ago he presented a very simple investment plan for the lazy man that he called the "Couch Potato" portfolio.  This plan consists of only two investments that he maintains will beat the market averages most of the time, and history has proven him correct thus far.  This plan involves investing half of your investable assets in the Vanguard Total Stock Market Index Fund (VTSMX)  and half in the Vanguard Inflation Protected Securities Fund (VIPSX).  This arrangement gives you the diversification of both stocks and bonds, and can provide the foundation for long-term investing.  It also provides a portfolio with very low management fees, which contributes mightily to long-term investing success.  He has since expanded this basic portfolio to include some investments that will increase diversification.  This will decrease overall investment risk, and I believe is a major improvement on the basic "Couch Potato" portfolio.  The next portfolio he calls the "Margarita Portfolio" because it, like the drink, has three ingredients,.  With this portfolio one would divide their investment into thirds with one-third going into the first two funds, (VTSMX and VIPSX) and one-third going into the Vanguard International Securities Index Fund (VGTSX).  Subsequently, for even more diversification, he has added the Four Square Portfolio, the Five Fold Portfolio, and finally the Six Ways From Sunday Portfolio.  This last portfolio would be invested thusly:  one-sixth into the first three funds mentioned above and one-sixth into each of these three funds: the Vanguard REIT Index fund (VGSIX), Vanguard Energy Fund (VGENX), and American Century International Bond Fund (BEGBX).  If BEGBX is still closed to new investors, substitute the SPDR Lehman International Treasury Index ETF (BWX).  The beauty of these portfolios is that they are simple, they do not require a lot of monitoring or time spent in research, and with the exception of BWX, they are with either Vanguard or American Century Investors (both customer friendly firms), and they can easily be re-balanced on a yearly basis.  Additionally, they help simplify your tax return, avoid calls from brokers with the latest tips, and avoid the expense of having someone else manage your investments.  And finally, with the Six Ways From Sunday Portfolio, you approach what I consider to be adequate diversification.  All good things!  For more info on these "lazy man" portfolios, "Google" Couch Potato portfolios.

In spite of my considerable appreciation for Vanguard's services, I still prefer to spread my little number around to include some other mutual fund providers.  Call it additional "diversification" if you will.   Likewise, though I have always admired the logic of index funds, I believe that I have been able to do just as well, and lower the volatility that my investments have experienced, by including some actively managed funds in the mix.

The investment allocation that I will suggest is intended for someone within three to five years of retirement.  If your retirement date is further into the future, I would suggest that more of your money be invested in equities.  If you are under the age of fifty, with several years of your work life in front of you, I would suggest that as much as 90% of your retirement funds be invested in equities, or other opportunities offering more growth potential than do bonds or cash.  If you are in retirement, past the age of 70, a 50/50 portfolio is appropriate.  Please note though, that an investment mix of 60% equities and 40% bonds/cash has historically returned only 1% per year less than an all stock portfolio, with substantially less volatility.  Volatility is what makes our knees weak.  It is during periods of extreme volatility, like we are experiencing now, that we start to question our investment plan.  The next thing you know we have made some emotional (versus logical) decision to "change" things, and it inevitably turns out to be just exactly the wrong thing, or the wrong time, to do so.  So avoiding excessive volatility is a good thing, especially as we near retirement, and a portion of our portfolio in bonds/cash accomplishes this.

So here is the investment mix I try to maintain for my retirement fund through yearly rebalancing.  Of course, I try to accomplish the rebalancing through tax sheltered accounts like my 401k or IRA.  This avoids a nasty tax bite which selling in a non-tax sheltered accounts generates.

  • Large Cap US Stocks --- 15%
  • Mid Cap US Stocks    --- 7.5%
  • Small Cap US Stocks ---7.5%
  • International Stocks  ---10%
  • REIT Mutual Funds   ---10%
  • Natural Resources/Energy/Precious Metals --- 10%
  • International Bonds  ---5%
  • US bonds/cash investments --- 35%

The specific mutual funds that I mention below which can be used to construct this portfolio are all no-load with very low management expenses.  As they say in the financial services industry, "Past performance is no guarantee of future results," but all of these funds have admirable track records.  Past performance is a wonderful predictor of management expenses however, and that is why I always prefer to use low expense funds.  Expenses ultimately come right out of the investor's pocket.  That is a bad thing to be avoided to the extent possible.

Large Cap US Stock Funds

  • Vanguard Equity Income Fund (VEIPX)
  • Vanguard Wellington (VWELX)  One of the oldest funds in the industry, and one of the most reliable.  It holds approximately 60% stocks and 40% high quality bonds, and has an excellent track record.
  • T. Rowe Price Capital Appreciation (PRWCX) Its investment policy is very similar to Vanguard Wellington; has experienced very few down years!
  • T. Rowe Price Blue Chip Growth (TRBCX)
  • Fidelity Contrafund (FCNTX)
  • Dodge and Cox Stock (DODGX)

Mid Cap US Stock Funds

  • Vanguard Mid-Cap Index (VIMSX)
  • Royce Premier Inv RPFFX)
  • Janus Orion (JORNX)
  • Bridgeway Aggressive Investors 2 (BRAIX)

Small Cap US Stock Funds

  • Vanguard Small Cap Growth Index (VISGX)
  • Fidelity Advisor Small CAp (FSCIX)
  • American Century New Opportunities II Inv (ANOIX)
  • T. Rowe Price Small Cap Value (PRSVX)

Internationa Stock Funds

  • Tweedy, Browne Global Value (TBGVX) This fund recently re-opened after being closed to new investors for several years.
  • Vanguard Global Equity (VHGEX)
  • T. Rowe Global Stock (PRGSX)
  • William Blair International Growth WBIGX)
  • Dodge and Cox International Stock (DODFX)

REIT (Real Estate Investment Trust) Funds -- These funds invest in a wide array of real estate investments.  I believe that every portfolio should include some investment in real estate.  Real estate is currently experiencing a cyclical downturn which presents an opportunity for patient, value investors.

  • Vanguard REIT Index (VGSIX)
  • CGM Reality CGMRX)
  • Cohen & Steers Reality Shares (CSRSX) One of the early leaders in REIT funds
  • Fidelity Real Estate Inv (FRESX)
  • Fidelity International Real Estate (FIREX)

Natural Resource/Energy/Precious Metals

  • T. Rowe Price New Era (PRNEX)
  • Vanguard Energy ETF (VDE)
  • Power Shares DB Commodity Index Tracking Fund (DBE)

Bonds and Cash -- One can easily construct a diversified bond portfolio, with the exception of international bonds, by using the various Vanguard bond funds.  Here are some excellent Vanguard funds.

  • Vanguard Total Bond Market Index (VBMFX)
  • Vanguard GNMA (VFIIX)
  • Vanguard Inflation-Protected Securities (VIPSX)
  • Vanguard Short-Term Investment Grade Fund (VFSTX)
  • Dodge and Cox Income (DODIX)
  • For international bond exposure, you may use either BEGBX or BWX, mentioned above.

For your cash holdings you can use CDs, savings accounts, or Vanguard's Prime Money Market Fund (VMMXX).  Most financial planners recommend that those of us in, or near retirement, keep a couple of years of "operating" expenses in a cash account.  This allows us to ride out periods of declining prices without having to cash in our equity positions during such periods in order to meet basic expenses.  This is an excellent idea!

By constructing a diversified portfolio using one or two funds from each category mentioned above you will have a portfolio designed to withstand the vagaries of the market and one with low expenses.  It will not require a lot of attention with the exception of some time spent periodically rebalancing it to reflect your own comfort level as it relates to risk.  I want to emphasize that often the best thing to do during periods of market volatility is nothing.  The markets eventually reward patience.  Create a plan, and then stick with it; unless you are forced to cash out at a market low, time is on your side.


Fly/Drive Safely

29 March 2008











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