last updated: Mar. 13, 2006

Keeping It Simple

The Basics

• Set up an emergency fund

The first thing you should do in allocating your money is to set aside an emergency fund, in cash. You never know what might happen with your job or health, so you need to be prepared for loss of income for an extended period of time. Most people recommend 6 months of living costs as a reasonable emergency fund.

Asset Allocation

So you’ve stashed away your emergency fund in a money market account, you’ve paid off your credit cards and car loan, and you’ve signed up for your company’s 401-K. Your 401-K and any additional money you invest on your own is what is designated for investment. So where do you put it?

Many people advise having a certain percentage in bonds, to give some stability to your portfolio and to provide some dividend income. Theoretically you raise the percentage as you get older, when you need more stability and income. A simple rule of thumb which I like (from John Bogle, former CEO of Vanguard) is to take your age and use that as the percentage of assets you hold in bonds. Easy and elegant! (As an aside, bonds can be quite a risky investment when interest rates are rising, because rising interest rates will cause the value of your bonds to decrease. In such times, I believe that holding this money as cash is reasonable.)

The remaining assets will go into the market.

Stocks: The Best Investment?

Mutual Funds are Better Than Stocks

Be Conservative

I try to stay conservative with my investments, because losses matter more than gains. If I gain 100% investments, that’s very cool. Order me up a new BMW. But if I lose 100%, then I’m out of the game. Or try this thought experiment. Let’s say that your investments gain 100% one year, and lose 50% another year. That sounds fine — a net 50% gain! However look what happens with a $10,000 investment: Hmm, that’s interesting. I end up with zero gain! It’s interesting that it happens no matter what the order. Remember: losses matter more than gains.

The Index Fund Advantage

Index funds seek to replicate the performance of one of the many indexes tracking the markets. The most well-known are the Dow, the S&P 500 Index, and the Nasdaq 100. They do this by simply holding the stocks of the companies in the index. By mindlessly following their indexes, these funds typically have very low expenses, and very low turnover.

Opposing the index funds are the actively-managed funds. These funds hope that their manager, by making shrewd stock picks, can outperform the indexes. However in practice index funds outperform over 75% of the actively managed funds. How does this happen? Really it comes down to cost.

Index fund expense typically average 0.2%-0.4% for U.S. indexes. Actively managed funds can have expense ratios of 1%-2%. So the active manager already has a

1% deficit that he must overcome just to match the market. It gets worse if the fund has high turnover. Turnover (or churn) adds on the commissions involved in buying and selling the shares within the fund. Unfortunately it’s hard to get a number on how much this actually costs, since the commissions are wrapped into the overall fund performance. John Bogle estimates it at 0.6% times double the turnover rate. Many funds average 50-100% turnover, so the cost is .6-1.2%. Finally index funds are more tax efficient. When funds sells stocks in their portfolio, any capital gains (hopefully you do have gains), are passed onto the customer and taxed. Since index funds rarely trade stocks, this gains stays in. Altogether this headwind of 3-4% is difficult to make up.

The other big advantage of index funds is diversification. Total market indexes rarely are the top performers in any given year. The top performers are typically investing in a specific sector (small stocks, tech stocks, energy stocks, etc.) But it is hard for a sector to outperform the market over a longer period of time. Witness technology stocks which shot the lights out in 1999-2000, then crashed horribly in 2001. So you can jump back and forth between the hot sectors to try to beat the market. Or you can just invest IN the market, and forget about it. As the saying goes, Conservative investors sleep well.

Think Global Young Man

With the large trade and budget deficits, and with increasing globalization, I believe that the U.S. markets will not outperform international markets like they have in the past decades. Also I believe the dominant theme of the coming decade will be the rise of China and to a lesser extent India, Brazil, and Russia as economic powers (the so-called BRIC countries). Because of this I would allocate some money for international funds. People seem to say 15-25%.

Model Portfolio

Here then is a simple model portfolio. Let’s say that you are 30 years old. Using index funds you could invest in:

The expenses for these 3 funds are .30%. 19%, and .31% respectively. I believe this simple portfolio would outperform most portfolios containing actively managed funds. And yet Wall Street will never promote this approach. They will always push the higher-expensed actively-managed funds, or even individual stocks with the commissions that are their bread and butter. And that, I feel, is the biggest disservice they do to their clients. Even worse, they may ask you to enroll in their ‘portfolio management’ program, and charge you an additional 1% for what you could easily do yourself!

Dollar Cost Averaging

One of the greatest ways to reduce risk is to invest over a period of time. This is called dollar-cost averaging, and is built into 401-Ks, which is another reason why that plan is so good. Let’s say that you had started investing in the market in 2000, the peak of the bubble. If you had put all of your money in at once, you might still be negative. But if you had done dollar-cost averaging, some of the money would have been invested at the high prices of 2000, but some would have been after the crash in 2001, and probably your investments would be doing okay.

So here’s how you do it: Figure out the amount of money you want to invest. Divide it by, say, 12, and invest that amount every month, divided between the U.S. fund and the international fund. This will reduce the risk of the market crashing right after you invest all of your money.

There is one big caveat. You need to invest in large enough amounts that the commissions you pay don’t become too high of a percentage. If you buy mutual funds through a brokerage like E*TRADE or Schwab, you can expect to pay $20-$30 per transaction. So for example, if you have $5000 to invest, you don’t really want ot break it up into $500 dollar chunks because then with a $30 you are already down 6%! In such a case I might divide it into two $2500 chunks and invest them 6 months apart. ETF commissions will be a bit lower because they are treated like stocks, but still probably $10-$20 per transaction. That’s why it’s nice to have an account with a company like Vanguard or Fidelity, because you can invest in their in-house mutual funds for zero commission. Incremental investments can be as low as $100 I believ.

Indexing Choices

Here are some ideas for index funds:

• U.S. Stocks

Vanguard Total Stock Market Index (VTSMX) — indexes the Wilshire 5000 and has expenses of just 0.18%. With this fund you’re getting practically the entire market, including a sizable portion of mid-cap and small-cap stocks. This would probably be my first choice if I had to pick just one fund.

Fidelity Spartan Total Market Index (FSTMX) — indexes the Dow Jones U.S. Total Stock Market Index, which apparently is every listed U.S. stock! Expense ratio is a very low 0.10%.

Vanguard Total Stock Market ETF (VTI) — indexes 3,000 stocks representative of the whole U.S. market. expenses = 0.07%

Vanguard S&P 500 Index (VFINX) — the one that started the whole indexing craze — just the top 500 companies. exp ratio = 0.18%

Fidelity Spartan 500 Index (FUSEX) — also indexes the S&P 500, with expense ratio 0.10%

A Note About ETFs

ETFs are really index funds in disguise. But because of the way the underlying stocks are bought, their expenses can be quite a bit lower than index funds (which already have low expenses). However you need to pay a commission on the purchase/sale. So which one is better is a bit debatable. Over the long-term, the lower expenses of ETFs will prevail. But this assumes that you are investing in large enough amounts that the commisions don’t hurt you. My biggest fear is that people will not dollar-cost average in order to save on ETF commissions, thereby opening themselves up to market risk. As an example, let’s say the index fund has .2% expenses, and the ETF has .1% expenses. Over 5 years, the difference is about .5%. Let’s say you are investing $2000. With $20 commissions (buy/sell), $40/$2000 is 2%, so you actually are losing with the ETF. This is a rough calculation and doesn’t take compounding into account, but these are the types of things you need to consider. Of course, if you invest through a fund supermarket like Schwab, you may be paying commissions even on mutual funds (and probably higher commissions). So check it out for your particular situation.