This is the second of several guest posts by Nathan Bush on 12 investing concepts.
CONCEPT THREE—EMERGENCY FUND
Everybody should have one. This eliminates the necessity of pulling money out of your retirement investment accounts when the stock market may be depressed or in a taxable situation. Size of the emergency fund is debatable. Some say three months; others say up to two years of living expenses. The size and composition of your emergency fund depends on your situation. In the Hypo-Folio, I have a relatively large cash balance and I-Bonds to make up my emergency fund. There are numerous ways to “skin this cat.”
CONCEPT FOUR—INDEX FUNDS
There are literally thousands of mutual funds and exchange traded funds (ETF’s) available to investors that fall into two categories: (1) Active-managed funds and (2) Index funds.
The active fund manager seeks to pick stocks of individual companies to place in or leave out of the fund in an attempt to “Beat the Market.” Numerous studies have concluded that these active funds can, but often do not, beat the market. If you factor in fees charged, expenses of frequent trading, and the excess tax liabilities, they almost never produce extra returns to the investor over what could have been obtained with a “do it yourself” (DIY) indexing approach. Indexing beats active 75% maybe 95 % of the time. Active investing is “a losers game”.
Index managers, on the other hand, do not pick stocks; they follow an index or group of stocks. Examples of popular Indexes:
Dow Jones Industrials-Dow Jones Co.-30 stocks.
S & P 500-Standard and Poor’s Co.-500 stocks.
NASDAQ-National Association of Securities Dealers-100 stocks.
Russell 2000-Russell Investments -2000 stocks.
Wilshire 5000-Wilshire Associates-5000 stocks.
The different brokerage houses (Vanguard, Fidelity, Schwab, and TD Ameritrade) all use the same or similar indexes to construct their funds. Most have both mutual funds and exchange traded funds (ETFs) that contain the same stocks, but the primary difference is that they are traded differently. Some investors prefer one to the other. In my Hypo-Folio, I use all ETF’s from either Schwab or Vanguard (bought and held at Schwab).
The most important aspect of a fund is its Expense Ratio (E/R) and the degree to which it covers the target market. Some investors use several different funds combined in different ratios to get the coverage they desire, or they will add a particular fund to “tilt” their portfolio in that direction. Also some funds combine both U.S. and International stocks. Some funds combine stocks and bonds to create a Balanced Fund (for example, Target Date Funds).
In most 401K plans, you are limited to just one fund family. Select the funds that are the closest match to the ideal. Start with the lowest cost.
This discussion could go on for several pages, chapters, books, etc. The take-away is that you should construct your portfolio to fit your needs, starting with basic funds to give you broad coverage at a low cost.
CONCEPT FIVE—PASSIVE (COUCH POTATO) PORTFOLIO
The syndicated columnist Scott Burns (Asset Builders) is credited with creating the original “Couch Potato” portfolio back in the 1980’s, which consisted of two funds: a broad market equity index fund and a broad market bond index fund (50/50) which could be rebalanced once a year in 10 minutes. Your requirements were that you had to be able to “fog a mirror” and “divide by two” in order to be a successful investor. He later sophisticated it (or complicated it, depending on your point of view) by adding a third fund, then a fourth, then a fifth etc. etc. all the way up to ten funds. Others have similar portfolios. The Bogleheads have a three or four fund portfolio; the Coffeehouse Investor uses 10 funds; Paul Merriman has “The Ultimate Buy and Hold” portfolio, which contains 12 funds. Jim Dahle (The White Coat Investor-WCI) did an extensive review of “150 Portfolio’s Better Than Yours” on his blog. The basic concepts are the same: broad diversification, using index funds with low cost, occasional rebalancing between equities (for growth), and fixed income (for ballast-stability).
There can and will be different funds, different fund companies, different ratios. Mistakes will be made. Some will outperform others. No one can predict the future. Keep it simple; stay the course. The perfect is the enemy of good. Do what fits your investment profile.