Diversified portfolio is good, but don’t get carried away
Browse the personal finance bookshelves at your local bookstore, and you’ll see dozens of elaborate ways to invest, ranging from trading carrot futures to renting condos in Cancun. But if you want to become a millionaire — or at least a multi-thousandaire — take a page from the Amish. Keep a simple portfolio. Wait for the statement in the mail, instead of checking it every 20 minutes on the computer. Be thrifty.
It’s not hard to construct a portfolio of dozens of mutual funds. Most people do it by accident, either by moving to companies with different 401(k) plans, shifting to a new broker or just choosing a new fund or two every year. A fund here, a fund there, and pretty soon your letter carrier has a hernia from lugging all your fund statements.
Even if you don’t get a big portfolio by accident, it’s not hard to build a complex portfolio on purpose. Morningstar counts nine varieties of diversified U.S. stock funds; Lipper has 12. Then there are international funds, sector funds, bond funds, money market funds.
Diversification is good to a point, but beyond that point, you’re just wearing out perfectly good letter carriers. How many funds should you hold?
According to Charles Schwab & Co., you should own no more than three actively managed funds per asset class: Large-company stocks, small-company stocks, international stocks. (They say one bond fund is fine, but if you want to go wild and have two, go on ahead.) The reasoning: The more funds you own, the more likely you are to duplicate the index. And if you duplicate the index, you’re much better off with an index fund, which costs less in the long run.
You’ll do much better if you choose different investment styles within each asset class. If you’re going to buy three large-company stock funds, it makes little sense to buy three growth funds, which search for stocks of companies with red-hot earnings growth.
An even more bare-bones portfolio would consist of one index fund per asset class. There’s not much sense in having two funds that track the Standard & Poor’s 500-stock index. If you want to compromise, use an index fund as your main holding and add another fund or two to make your portfolio more or less aggressive.
A 20-year-old, for example, might put 50 percent of his stock portfolio in an index fund. Another 25 percent might go to a small-company core fund, which looks for reasonably priced stocks of small, growing companies. A 50-year-old might put just 15 percent in a small-cap value fund, which prefers small, undervalued companies.
If you’re going to simplify your portfolio, look for duplicate holdings first. If you decide to add a new fund, ask yourself if it will help diversify your holdings. As a rule, you should seek funds that don’t march in lockstep with your core funds.
For example, international small-company core funds have a low correlation with S&P 500 index funds, as do real estate funds, gold funds and Pacific region funds. These funds have a chance of rising when your main funds fall. Norman Fosback, editor of Fosback’s Fund Forecaster, also recommends micro-cap funds, which invest in the very smallest companies.
Once you’ve set your portfolio, how often should you fiddle with it? Not very. Even if you’re not counting commissions or taxes, overtrading is counterproductive. Suppose you had a portfolio of 60 percent stocks and 40 percent bonds. You invested $10,000 10 years ago. (We’re using the S&P 500-stock index and the Lehman Aggregate Bond index here for illustrative purposes.)
If you rebalanced your portfolio every month — a Type A approach if there ever was one — you’d have $23,732 now. Not bad.
If you rebalanced only when your portfolio was 5 percentage points out of kilter, however, you’d have $24,213, and you would have rebalanced seven times in the past 10 years. If you waited until it was 10 percentage points out of whack, you’d have rebalanced twice — and have $24,436 in your account.
Finally, you should realize that the biggest factor in how much you have in your account is the amount you put in — not how much you earn. Let’s say Person A puts away $1,000 a year and earns 10 percent each year. After 20 years, she’ll have $63,000.
Now let’s say Person B is not brilliant, but is thrifty. He puts away $2,000 a year and earns 5 percent. After 20 years, he’ll have $69,000. Granted, if Person A earns 10 percent long enough, she’ll beat Person B. But earning 5 percent over several decades is a surer thing than earning 10 percent.
You don’t have to trade in your car for a horse if you want to follow Amish Portfolio Theory. You just have to keep it simple. A good idea with most things.