Three Examples of Successful Investing Portfolios

Posted on July 9, 2011 by Darren

The following tables show you the details of three portfolios. All are true to successful investing goals and appropriate for semi-retirees. Pick the one that’s right for you, and start building your wealth.

Listed from least to most complex, the third portfolio features the best performance with lowest volatility. However, you’ll need to put in a bit more effort to build it.

Option One: Two-Investment Portfolio

The first option uses just two investments: a 60%/40% blend of the S&P 500 and T-bills.

This portfolio would have very low fees. The S&P 500 ETF from Vanguard costs 0.06% a year, and T-bills can be purchased commission-free straight from the Treasury Direct. This results in just $36 of fees on a $100,000 portfolio.

As for performance, this combination had an average return of 9.19% from 1988 to 2006. Volatility was pretty low, with a standard deviation of 8.67%.

Option Two: Eight-Fund Portfolio

Despite the simplicity of the two-investment approach described above, you may want more diversification. If so, you can achieve this with just eight funds and a money market account.

Better yet, some funds are available as an ETF, which means lower fees for you.

Percent of Portfolio	Mutual Fund Symbol	ETF Symbol	Description
20%	VFINX	VOO	S&P 500
8%	VTMSX		Tax-Managed Small-Cap Stocks
6%	VGTSX	VXUS	Total International Stock Index
10%	VINEX		International Explorer Fund
6%	VEIEX	VWO	Emerging Markets Stock Index
30%	VBIIX	BIV	Intermediate Bond Index
11%	BEGBX*		Foreign Bond
5%	VGSIX	VNQ	REIT Index
4%	VMMXX		Prime Money Market

*Though the foreign-bond fund isn’t a Vanguard fund, you can still buy it through your Vanguard account.

Your annual return, measured since 1988, is 8.6%. With a standard deviation of 6.7%, volatility is even lower than the first option mentioned above. Most importantly, you can build this portfolio easily within a single brokerage account at Vanguard.

Fees for this portfolio average 0.32% per year.

Option Three: 16-Asset Portfolio

If you’re really serious about investing, consider this portfolio with 16 asset classes.

From 1988 to 2006, returns averaged 10.2%. Volatility, measured by standard deviation, was just 6.86%.

If you go this route, you may need to purchase Dimensional Advisor Funds. These are only available to individuals through a DFA-approved financial advisor.

Stocks

Asset Class	Percentage Allocation	Funds	ETF	Notes
U.S. Large	12%	VFINX	VOO	Growth
		DFBMX		Enhanced Value Index
U.S. Small	8.5%	VTMSX		Value/Growth Blend
		VISVX	VBR	Small Cap Value
		DFSVX		Small Cap Value
International Large	5%	VEURX	VGK	Europe Index
		DFIVX		Value
International Small	10%	VFSVX	VSS	Index
		DFISX		Blend
		DISVX		Value
Emerging Markets	6.5%	VEIEX	VWO	Index
		DFEVX		Value

Bonds

Asset Class	Percentage Allocation	Funds	Notes
Money Market	4%	VMMXX	Money Market
		VFSTX	Some Credit/Interest Risk
Treasuries	4%	VIPSX	Inflation-Protected
		U.S. Treasuries	Buy from Treasury Direct
U.S. Medium-Term	10%	VBIIX	Corporate
International	12%	BEGBX	Index
		DFGFX	Hedged
High Yield	4%	VWEHX	Higher Quality
GNMA	5%	VFIIX	Mortgage Securities

Other

Asset Class	Percentage Allocation	Funds	Notes
Oil & Gas	3%	VGENX	Energy Equities
		GASFX	Natural Gas
Market Neutral	2%	MERFX	Higher Fees
		ARBFX	Higher Fees
Commodities	4%	QRAAX	Overweight Oil
		PCRIX	Preferred
Real Estate	5%	VGSIX	Index
		EGLRX	Foreign Real Estate
Private Equity	5%	AINV
		ACAS

At first, looking at this list may overwhelm you. But if you think this portfolio is right for you, yet you feel like buying and selling to bring your portfolio into alignment with these allocations is gut-wrenching, take it slow.

You might want to move half of the allocation in one month, and the balance over the next six months. But the bottom line is, just do it.

Rebalancing

Rebalancing your portfolio is an important part of keeping your investments on autopilot. By selling some of your winners to buy more of the losers, you’ll bring your portfolio back to its original allocation.

Rebalancing once every year or two is about the right frequency.

How to Rebalance

Suppose your portfolio has grown from $1,000,000 to $1,055,000.

If you need 33% of your assets in U.S. Stocks, then 33% of $1,055,000 is $348,150. But let’s say the value has actually grown to $400,000. Now, you’re overallocated by $51,850.

And if 40% of your assets should be in U.S. Bonds, then 40% of $1,055,000 is $422,000. But if your bond holdings were worth only $350,000, you’d need to purchase $72,000 worth of bonds to bring its allocation up to it’s correct level.

By selling $51,850 worth of U.S. Stocks, as well as your other assets that are overallocated, you can restock the U.S. Bond fund – and all the other funds that are underallocated too.

In the end, all buying and selling will net out to zero.

To learn more about successful investing portfolios, check out Work Less, Live More.

6 Principles of Successful Investing

Posted on July 2, 2011 by Darren

The following rules form a sound, effective, and easy-to-use investing method. Stick to them, and they’ll lead you to a successful semi-retirement.

Own Diverse Asset Classes

Successful investing starts with creating a portfolio with the right assets. This means combining stocks, bonds, and other non-correlated assets that’ll give you the same – or better – returns than individual securities from just a few asset classes.

This works because small amounts of volatile – yet high-return – assets will increase your overall portfolio performance with little additional risk.

When one asset increases while another decreases, your overall portfolio stays steady.

Here’s a secret: All the big successful institutions invest this way to ensure a safe provision of steady income.

They don’t spend time picking stocks and bonds. They just pick asset classes that have worked well together in the past, and find managers who deliver that asset class’s performance consistently and at a low cost.

For most investors, a rational portfolio will consist of 40% stocks, 40% bonds, and 20% other – including commodities, market neutral hedge funds, and real estate. Since these assets are less correlated with the main stock and bond asset classes, they’ll provide real benefits to your overall results.

There are three benefits to following this allocation method:

It can be used by both younger and older investors.
It supports steady withdrawals through all kinds of markets.
It has a good chance of keeping up with inflation.

Demand Low Fees

Your portfolio’s fees should average below 0.5% a year. And by choosing certain funds, you can lower your fees even more – down to the range of 0.2% per year. Fees higher than this just eat up too much of your expected return each year.

To determine your fees, check out your fund’s prospectus. Or go to Morningstar and enter the ticker symbol.

In the past, fund management companies only offered these low prices to large institutional investors. Luckily, they’re now available to average investors too.

For instance, you can get international small stocks, emerging market stocks, international bonds, and other previously hard-to-get assets at fees in the 0.2% to 0.5% per year range.

Use Tilts

A portfolio has a tilt when it holds more of an asset class than normal. For instance, the Total U.S. Stock Market Index contains under 7% small stocks. So a portfolio with more than 7% small stocks is tilted toward small stocks.

International stocks and bonds, as well as small stocks, are good asset classes to tilt towards. Their low correlation with other assets mean they can lower your overall portfolio risk while providing good returns.

Keep Volatility Low

Volatility refers to the up and down swings in the value of your portfolio.

For instance, the S & P 500 is pretty volatile. Although its average return from 1988 and 2006 was 11.8 percent per year, actual annual returns fluctuated widely.

Some years had big gains, while others had big losses. This distribution is measured by what’s known as standard deviation. For the S & P 500, this number is 14.75 percent.

What this means is that, in any given year, the S & P 500 to fall – with 68 percent certainty – within one standard deviation above or below the average return. In other words, between -0.3 percent and 26.5 percent.

If you move two standard deviations away from the average – between -17.7 percent and 41.3 percent – your returns will fall in this range 95 percent of the time.

So what’s the point?

If you’re looking to retire early, don’t try to achieve the highest return at the expense of high volatility. Instead, choose a mix of assets to provide an acceptable return at the lowest risk. This usually means lower amounts of stocks than other long-term investing models promote.

Steven Evanson of Evanson Asset Management offers a useful guideline as it relates to risk and reward: For every 10 percent of stocks you hold, your portfolio’s value could decrease as much as five percent.

Stick to Index Funds

Indexes approximate the returns of different market segments. Often, an index will overlap neatly with an asset class you want to have in your portfolio.

Usually, the index consists of most of the significant securities that make up that asset class in proportion to their size. They normally go through yearly changes. Some securities are added, others fall out, and the weights of those staying in the index adjust to reflect their changes in value from the prior year.

With this said, an index is only an approximation of the actual returns for the asset class and tilt you’re looking for. But when the match is close, your best choice for the portfolio is a low-fee, tax-efficient index fund or ETF.

But there isn’t always an index fund available that matches your needs. And a tilt may also not have an index that properly tracks it. Take international small stocks and international large value stocks, for instance.

In these cases, you’ll need to find a low-fee actively-managed fund.

Know Your Required Return

Though it’s possible to create a portfolio with no risk, it won’t provide an adequate return. As a semi-retiree, your portfolio must grow against the following three forces:

Inflation – about 3 percent
Fees and trading costs – about 0.5 percent
Your annual withdrawal – about 4 percent

Adding these demands on your portfolio, you need at least a 7.5 percent return to keep the real value of your portfolio intact.

To learn more about successful investing principles, check out Work Less, Live More.

Five Investment Myths Exposed

Posted on June 25, 2011 by Darren

Successful investing isn’t rocket science. But to grow your wealth, you must move past the following unproductive investment myths.

Myth 1: I’ll Just Find a Hot Fund Manager

Finding fund managers with great track records may seem like a smart thing to do. But expecting to find ones who’ll keep beating the market in the future is next to impossible.

After accounting for fees, only about 25 percent of fund managers outperform their relevant index in any year. Even worse, if you stretch the period to three straight years, just 10 percent of managers outperform.

Vanguard’s John Bogle calculated that the average stock fund returned just 9.9 percent a year over a recent 20-year period. Viewed alone, you may think this is good performance.

But contrast this with the S & P 500 Index, which returned 13 percent over that same period. That’s 3.1 percent better than the average fund!

Though it’s possible to find a fund that outperforms for a few years, you can never be sure if THIS year will be the LAST.

Here’s the truth. You don’t need to find the perfect manager. Just follow these steps:

Study how your entire portfolio responds in different market conditions.
Learn how your various asset classes interact.
Determine the optimal amount of each asset to own.
Find managers who’ll deliver that asset class consistently and at a low price.

Myth 2: Bonds are Useless

If stocks grow at about 12 percent a year and bonds average 6 percent, you shouldn’t bother with bonds, right? After all, wouldn’t you do much better in the long run by sticking to 100 percent stocks?

Sure, you can load up on stocks – IF you don’t need your money for a long time. But if you want to leave traditional full-time work sooner and semi-retire, you’ll need to make withdrawals every year. You’ll need to sell some of the stocks in your portfolio even if the market drops – which can hurt its chances of recovering.

In other words, by investing in 100 percent stocks, you’re ignoring one important thing:

Volatility.

The higher the expected return, the greater the risk.

If stocks are your only asset and you need to sell every year, you could lose everything. But if it’s only a portion of a balanced portfolio, you’ll be in good shape.

Myth 3: All-Bond Porfolios are The Answer

This is the opposite of Myth 2.

You may think that with all bonds, you won’t need to think about asset allocation or risk. But you’d be wrong.

Why?

Because this myth neglects inflation. In other words, this strategy will surely destroy the real value of your portfolio and its withdrawals.

So the challenge is to set aside the first three percent of yield each year for inflation. After that, you can make safe withdrawals knowing that the real value of your portfolio will stay intact.

But if you stick with all bonds, there may be little left – much less than the four percent you want to withdraw. For instance, in the past bonds have returned just three percent after inflation. TIPS and I-bonds have real returns of just two percent.

So it’s stocks that are the primary asset class that gives you adequate protection against inflation, with enough for withdrawals. Supporting a four-percent withdrawal rate requires this diversified portfolio of riskier yet better-performing assets.

Myth 4: The S & P 500 Index Is the Entire Stock Market

You may have been told that rather than trying to pick funds, you should just load up the equity portion of your portfolio in an S & P 500 index fund.

Though this approach better resembles good long-term investment principles, the S & P 500 is just a part of the world’s stock market.

Twenty-four stocks make up 33 percent of the weight of the index, and the bottom 150 stocks make up just five percent of the index weight. This means that limiting your portfolio to the S & P 500 ties you to the fortunes of just a small fraction of America’s firms.

To get real diversification, you need to go beyond the S & P 500 and into less-correlated assets. These include small stocks, international stocks, and value stocks.

Myth 5: Foreign Assets Are Unnecessary

Some people think U.S. companies are bigger and safer than all the other ones in the world. They also believe that since American firms are global nowadays, their success overseas will be reflected in the U.S. stocks.

With these beliefs, people think they don’t need to bother with foreign stocks.

But it’s important to note that U.S. stocks and bonds make up just 40 percent of the world’s financial assets.

So by investing overseas, you can now add low-correlation asset classes to your portfolio. It’s safe, cheap, convenient, and offers potential for great returns.

To learn more about investment myths and their actual truths, check out Work Less, Live More.

Important Investment Terms For Building Your Wealth

Posted on June 18, 2011 by Darren

For many, the most intimidating thing about the investment world is the strange language that’s used. If you’re one of them, don’t worry. Here are simple definitions for common and important investment terms.

Asset Classes

These are types of financial instruments that are classified by group. For instance, we have

large U.S. stocks
large international stocks
small U.S. stocks
small international stocks
emerging market stocks
short-term corporate bonds
long-term U.S. government bonds
medium-term U.S. bonds
international bonds
commodities
commercial real estate

Diversification

This means two things:

Owning different securities within an asset class, and
Owning several different asset classes

One asset class will usually increase in value while another decreases in value at the same time. When this happens, the two asset classes are less correlated – which is important.

What this means is that including both asset classes in your portfolio will make it less unpredictable. It’s value will tend to increase gradually over time, rather than have huge increases and decreases.

Fees

These are what you pay your brokerage firm for its services.

Average investors pay about 1 percent of their portfolio’s value each year in fees, and possibly another 1 percent for hidden trading costs that active mutual funds incur as they try to beat the market.

John Bogle, founder of the Vanguard investment firm, calculated that that fees and commissions on U.S. stocks cost investors about 3 percent every year.

In contrast, solid funds with low fees are now available to the everyday investor. With these funds, you can expect to pay a mere 0.4 to 0.6 percent – well below the average.

By keeping more of your money and staying invested, your portfolio will not only grow larger in the long run – it’ll do fairly well in the short run too.

Mutual Funds and Exchange-Traded Funds

These are pooled investments that let you own a piece of many securities – more than you’d likely be able to buy yourself.

There are two types of mutual funds: actively-managed funds and index funds.

Actively-managed funds are led by a manager who tries to beat the index, which is the average of the securities in that asset class.

On the other hand, index funds own nearly every security in the index. Because of this, they end up matching the returns of the asset class. Since they don’t try to decide which securities will increase or decrease and just buy all of them – index funds have much lower expenses.

Digging deeper, the average mutual fund charges investors about 1.3 percent to manage its assets. Compare this with exchange-traded funds (ETF’s), which cost less than 0.2 percent on average.

ETF’s are like index funds, but they’re bought in a brokerage account. Their price goes up and down as they’re bought and sold several times a day.

Mutual funds are bought from the mutual fund company. They’re only bought once a day, at the end of the trading day when the financial markets close.

And even though ETF’s distribute dividends and interest just like mutual funds, they’re still more tax-efficient. This is because few, if any, capital gains are realized when shareholders sell their shares.

Rebalancing

This is a three-step process that consists of

Starting with broad and conservative asset allocations
Staying invested, and
Trading infrequently (such as once every year or two)

You’ll sell some of your winning investments, and buy more of those that lost value. Doing this just occasionally will keep trading expenses low.

And because you’re diversified, a sharp drop in one asset class won’t hurt your overall portfolio too much.

By using this disciplined rebalancing approach, you’ll follow the time-tested advice to buy low and sell high – rather than making decisions based off your unreliable emotions.

Tax-Efficient Investing and Tax-Efficient Funds

These concepts seek to reduce taxable capital gains distributions – especially short-term gains in which you’d pay higher taxes. This is accomplished by trading less, which an index fund does.

These funds also discourage investors from frequent buying and selling, since you must pay taxes for these exchanges. Long-term investors benefit from these funds the most. Because they seek to simply accumulate capital gains within the fund indefinitely, tax payments are delayed.

ETF’s, which we discussed above, are usually the most tax-efficient of all funds.

Value Stocks

These are offered at bargain prices. The idea is to buy these riskier investments that are out-of-favor at the moment. By taking this chance, you can be rewarded with better-than-average returns over the long run.

Adding value stocks to your portfolio in percentages higher than their presence in the entire universe of stocks is called giving your portfolio a value tilt.

To learn more about important investment terms and how they’ll help build your wealth, check out Work Less, Live More.