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One of the age-old questions when it comes to investing is how to actually construct a portfolio.  Part of the difficulty relates to the fact that there is so much “noise”.  By “noise”, I mean information that comes out on a daily basis which might change your opinion on what to invest in, how to adjust your portfolio, and whether or not you should sell all your stocks and bonds.  It can be quite confusing.  If you watch business TV shows, you will likely see several guests with different opinions.  I usually find that one guest will say that the stock market is poised for a big increase, another money manager will point out why the stock market might fall quite a bit, and we might have a technical  trader say that the stock market is likely to consolidate (i.e. not really move up or down too much).  Well, if you think about things from that vantage point, you are really not getting much information that should affect your risk tolerance and your decision on what investments are best for you.  The guests on business TV shows are telling you this:  on any given day, the stock market might go up, it might go down, or it may be unchanged.  Everyone knows this to begin with!  Today’s big news becomes a backburner item quite quickly.  For example, do you remember the fiscal cliff, sequestration, and Portugal/Italy/Greece/Spain  downgrades on sovereign debt?  It used to be news that was so important that it dominated TV coverage, financial newspaper articles, and even mainstream nightly news.  Long story short, if you have a long-term time horizon, everyday news is not really important to you.  In fact, when you are beginning to invest, I would recommend not trying to keep up with financial news.  The best course of action would be to read a book or two about asset allocation and how the financial markets work in general.

Setting up an investment portfolio is intimidating.  The financial services industry has done its best to drill it into your head that the process is so difficult you have to come to them for advice.  Now that advice comes at a price.  You will usually have to pay a fee based upon your total assets that they management which is referred to assets under management (AUM).  An AUM fee is normally around 1% per year.  Therefore, if you have $1 million, you will pay your Financial Advisor $10,000.  As an aside, whenever you do seek out advice from financial professionals, you should always ask about the fee in percentage and absolute terms.  Why?  Well, 1% does not sound like too much, but writing a check for $10,000 is a different story in terms of how you view the benefit of going to that financial professional.

In reality, setting up a diversified portfolio is easier than you might think.  There was a recent story in the Wall Street Journal which really elucidates my point.  See this link:  http://online.wsj.com/article/SB10001424127887323566804578551793835572924.html?mod=rss_mobile_uber_feed.  Now if we start things off without looking at your risk tolerance (how comfortable you are investing in stock, bonds, or other financial instruments), you can create a simple portfolio.  I will not pitch any particular investment.  To start things off, I strongly recommend that you start off with passive investment vehicles.  Passive investment vehicles would be Exchange Traded Funds (ETF) or index mutual funds.  An ETF is simply a stock traded on a stock exchange that represents a basket of stocks tied to an index like the S&P 500.  You are able to buy/sell the ETF during market hours.  An index mutual fund is a pooling vehicle.  The mutual fund manager combines your investment dollars with other investors and buys stocks and/or bonds in an index on your behalf.  You are buying shares in the mutual fund, and you can buy/sell once a day when the financial markets close.  Your share amount is based upon the mutual fund’s Net Asset Value (NAV) which is a fancy way to say the “stock” price of the mutual fund.  ETFs and index mutual funds have the advantage of extremely low expenses.  Most passive investment vehicles have an expense ratio (annual fees) of 0.20%.  If you went to a Financial Advisor, you would still have to pay his/her 1% AUM fee and your investment return would be lower by that same expense ratio if your financial professional suggests an ETF or index mutual fund.

You can set up a portfolio with just ETFs.  As in the aforementioned WSJ article, you might decide that you have 30 years to retirement, so you are fine with owning 80% stocks and 20% bonds in your portfolio.  How do you actually implement this?  One example would be to purchase the Vanguard Total Stock Market ETF (55% Ticker Symbol VTI), Vanguard Total International Stock ETF (25% Ticker Symbol VXUS), and Vanguard Total Bond Market (20% Ticker Symbol BND).  Their expense ratios are 0.05%, 0.16%, and 0.10%, respectively.  As I have mentioned in previous posts, you will never earn an investment return better than any of those indexes.  However, it is extremely difficult for money managers to beat those indexes over the long-term (five or ten years) as well.  Refer to http://t.co/nlz2h1WDkG.  At this point your financial professional will be up in arms and chomping at the bit to tell you that this type of advice is way too simplistic.

I will admit that the concept is simple.  However, there is another way to approach your investment portfolio.  Within the last decade, mutual fund families have developed what are
referred to as life-stage funds.  A life stage fund is a mutual fund that has a year associated with it and is meant to coincide with when you retire.  An example would be that, if you are 50 years old and would like to retire when you are 65, you might buy a fund that has a 2025 year associated with it.  Let’s take a look at this concept a little closer.  Vanguard has a Target Retirement 2025 (Ticker Symbol VTTVX).  When you look at the underlying components of this mutual fund, it has 70% stocks and 30% bonds.  More specifically, it owns 49% US Stocks, 21% International Stocks, 24% US Bonds, and 6% International Bonds via Vanguard ETFs.  There are also two competing mutual fund complexes (among others) that offer similar products.  They are Fidelity and T Rowe Price.  The corollary mutual funds would be Fidelity Freedom 2025 (Ticker Symbol FFTWX) and T Rowe Price Retirement 2025 (Ticker Symbol TRRHX).  These funds work well for investors who wish to “set it and forget it”, but you must realize that the mutual fund family will charge you a fee for this service.  Using my example above the Vanguard expense ratio is 0.17%, the Fidelity expense ratio is 0.72%, and the T Rowe Price expense ratio is 0.73%.  I personally believe that those expense ratios are too expensive, especially the Fidelity and T Rowe Price offerings.  Remember that you will pay the expense ratio and also the expense ratio of the underlying ETFs and/or mutual funds.  There is a way to get around that though.

All the mutual fund families have to report their underlying components on a quarterly basis.  If you go on their respective websites, it is possible to see their holdings.  When you look at the Vanguard Target Retirement 2025 fund, you can just buy the four ETFs yourself.  You will pay a commission to your broker; however, you will avoid the expense ratio of the mutual fund which is 0.17% in this case.  Now if you have $100,000, you would save $170 per year.  On an annual basis, you can look at the holdings and adjust your personal portfolio accordingly.  There is even a way to avoid brokerage fees altogether.  Fidelity offers a plan where you can buy iShares ETFs with no commission.  The list is as follows: https://www.fidelity.com/etfs/ishares-view-all.  Now your broker will not particularly like it, but it is in your best interest to keep your expenses as low as possible.  There are iShares that will mirror the components in the Vanguard Target Retirement 2025 mutual fund.  The expense ratios are similar, plus you get the bonus of being able to invest additional funds on a monthly basis in small increments.  For example, if you only have $150 to add to your portfolio on a monthly basis, you can purchase small numbers of shares for free.  Well, your financial professional will be steaming at this point and tell you that your risk tolerance must be analyzed closer.

It is very true that investors are risk averse or risk takers.  How can you account for differences in your risk tolerance?  Well, let’s say that you are just starting off investing and just want to wade in.  You do not have to purchase the target date fund that matches your retirement date.  You can simply choose to purchase the 2020 fund.  The 2020 fund will be more conservative and have less exposure to stocks.  Now the corollary would be to invest in the 2030 fund or later if you would like to take on more risk.  Measuring your risk tolerance is quite difficult.  Your financial professional will usually have you fill out a questionnaire in order to assess it.  Always remember that your answers on paper should be converted to absolute dollars.  I mean this in terms of any questions that ask if you are fine if the stock market might go down 20% in any one year.  You might be fine with this.  Think about it this way though.  If you have $1 million and want to retire in a couple of years, what if your portfolio went down to $800,000 to start the next year?  How do you feel about that?  Actual numbers make it more real and provide context.

I cannot stress enough that participating in monthly buying programs of shares offered by brokerage firms is a horrible idea.  For example, you might find a firm that will allow you to purchase more shares for $4 per trade on a monthly basis.  This commission is very low, but what if you only have $100 to invest monthly?  The $4 commission really is a 4% fee.  Furthermore, the stock or ETF has to go up 4% before you can sell it to break even.  Thus, the stock needs to increase 8% for you to have $100 after you pay commissions.  The long-term, historical return on stocks is roughly 7.25%, so in the case above, you are sacrificing one year’s return to invest on a monthly basis.  You are much better off searching for an index mutual fund.  An index mutual fund will allow you to purchase more shares at the current NAV at no additional charge.  It is a great way to hold down expenses.

In the next part of this discussion, I will talk about measuring your investment performance.  Your financial professional will tell you that he/she can help you navigate the troubled waters and confusing developments taking place currently in the financial markets.  That financial professional is definitely correct and will have financial advice ready from his/her firm.  With that being said though, you are going to pay for that advice.  In the example first used, if you have $1 million, you are going to pay $10,000 if the AUM is 1%.  You may decide though that it is worth your time to learn about investing to avoid the fee.  At the very least, learning how to properly construct a performance benchmark will allow you to see the benefit (or lack thereof) of your financial professional.

If you would like more information regarding possible portfolios, here are a couple of links: