Building Your Portfolio, Part 3: Specific Investments

Building Your Portfolio, Part 3: Specific Investments

Welcome to Part 3 of my Building Your Portfolio series of blog posts.  In Part 1 we discussed the types of accounts you should consider in building the foundation of your investment portfolio.  In Part 2 we reviewed the basic concepts of asset allocation and simple strategies for starting your investment portfolio. 

Today I’d like to talk about choosing specific investments.  As with the first two posts in this series, we’ll stick to the basics.

Disclaimer: Please remember that I am not a financial professional. This blog post is for informational, educational, and entertainment purposes only, and not financial advice.  Please consult a financial planner, financial advisor, certified public accountant, or other financial professional before making decisions regarding your investments, taxes, retirement, and finances.

Before we get into the meat of the discussion, I think it would be wise to review some basic definitions.  After all, how can you make educated choices about specific investments if you don’t have the financial literacy to understand what you are investing in?  

Stocks

A stock is a type of security that gives its owner, a stockholder, a share of ownership in a given company.  Basically, when you buy a stock, you literally own a small piece of that parent company.  Another name for stocks are equities. 

Bonds

A bond is a loan you are giving to some entity, usually a government or corporation.  A certain sum of money is loaned to the borrower for a defined period of time.  The borrower pays interest on the loan each year, and at the end of the term the money is returned.  These terms are fixed when the bond is issued, and for this reason, bonds are also often referred to as fixed income.

Mutual Funds 

A mutual fund is an investment vehicle within which funds are pooled from various investors to purchase a collection of securities.  This usually consists of stocks, bonds, or a combination of both.  By owning a share of the fund, you own a small piece of all the things the fund invests in.  There are many different subsets or types of mutual funds.

Some mutual funds are actively managed.  This means the person in charge of the fund chooses which securities to hold within the fund.  They actively buy and sell certain securities based on market trends and research to try and beat the market.  These funds charge a fee for these services, which can significantly impact their overall return.  An example of actively managed funds getting a lot of press lately include the various funds from ARK. 

Some mutual funds are passive and follow an index, such as the S&P 500, and thus they are called index funds.  These funds buy and hold securities in line with the index they track.  They aren’t trying to actively beat the market, but rather earn the market return of their respective index.  Because index funds simply mirror the index they follow, it requires much less research from analysts and advisors.  This significantly reduces the fees associated with these funds, making them a favorite among the FI community.  Probably the most well known example of an index fund is VTSAX, the Vanguard Total Stock Market Index Fund.

An exchange traded fund, or ETF, is another common variation of a mutual fund.  Unlike a mutual fund that can only be purchased or sold at the end of the trading day, ETFs can be bought or sold at any point during the day just like individual stocks.  I think it’s easiest to think of an ETF as a different wrapper on the same fund.  For example, VTSAX is the mutual fund version of the Vanguard Total Stock Market Index Fund, whereas VTI is the ETF version.  They both hold the same underlying stocks (every publicly traded company in the U.S.) but have different “wrappers.”  There are some other subtle tax and advanced trading benefits to ETFs, but we will keep it simple for now. 

Target Date Funds 

A target date fund or life cycle fund is essentially a “fund of funds.”  They are offered by most major brokerages, such as Vanguard, Fidelity, Schwab, etc.  Target date funds contain a collection of broad based index funds holding stocks and bonds in proportion to your expected retirement age.   The holdings in these funds shift from a more aggressive asset allocation when you are younger to a more conservative allocation as you approach retirement.   Each different fund is based on your expected retirement age.  Let’s look at an example to better understand how this works.

Let’s analyze the Vanguard Target Retirement Funds and use me as an example.  I was born in 1979.  Here is a screenshot from the Vanguard website:

If I hover my mouse over the range that covers my birth year, it shows a target retirement of 2045.  This gives me an approximately 25 year time horizon until retirement.  Let’s look at the Vanguard Target Retirement 2045 Fund:

You can see that as of 1/31/21, the portfolio holds ~90% stocks and ~10% bonds.  Most would consider this an aggressive portfolio, which makes sense given the 25 year time horizon.  

The appeal of these funds is that they do all of the heavy lifting for you.  You simply have to invest in one fund, and then they allocate it to investments based on your time horizon to retirement.  As you approach retirement, the fund changes the asset allocation more towards bonds over time.  If we look at the Vanguard Target Retirement 2020 Fund, you can see it is approximately a 50/50 asset allocation:

Another important point is that target date funds generally have low fees, since the underlying funds are index funds.  The overall expense ratio is just slightly higher than the underlying index funds due to the “active” change of asset allocation over time.  

For hands off investors that want to “set it and forget it,” target date funds are a great option.  Not only are they very well diversified, automatically change your asset allocation over time, and have low costs, they also make investing very simple since you only have to contribute to one single fund.  For these reasons, target date funds continue to increase in popularity.

Alternative Assets

Finally, a note on alternative assets.  This could include real estate, gold, cryptocurrency, commodities, fine art, etc.  Check out my post on alternative assets in my FI Step by Step series for more thoughts on alternative asset classes.  

What Should You Choose?

So, with these basic definitions in mind, what specific investments should you choose?  Here are six guidelines I believe you should follow when choosing investments:

#1 Only invest in something you understand

If you don’t understand the investment, you probably shouldn’t be putting your hard earned money into it.  This is one of Warren Buffet’s rules, and I completely agree.  If you don’t understand it, you’re probably going to lose money. 

This may sound overly simple.  For example, you may think “If I’m investing in a mutual fund, then I’m simply investing in the stocks it holds.”  However, there is much more to it than this.  

What specific securities does the fund hold?  Is it actively or passively managed?  What are the fees?  How will this investment make you money?  Does it pay a dividend?  How are you taxed on this investment?  Does it matter if you hold this investment in a tax advantaged vs taxable account?  How will you get your money back?  These are just some of the things you need to understand.

Common examples of poorly understood investments that people often regret include actively managed mutual funds with sky high expense ratios, complex insurance products such as permanent life insurance and annuities, and time shares.   

#2 Choose investments consistent with your financial goals

Your investment choices should be consistent with your financial goals.  This is largely determined by your asset allocation, but also applies to choosing specific investments.  Put simply, you need to choose investments that appropriately fit within that allocation.  

If your goal is wealth accumulation for retirement, investing all of your money in safe, but low yielding investments, such as CDs and government bonds, likely won’t get you there.  If you want to beat inflation and reap the benefits of compound interest, you are going to have to accept some risk and choose higher yielding investments, such as a stock index fund.  

Conversely, if your primary goal is to preserve wealth and live off your current portfolio, you’ll likely make less risky, lower yielding investments a larger part of your portfolio, like a bond index fund.    

#3 Choose investments you can stick with

If you are investing with a long time horizon, make sure the investments you choose are something you can stick with for the long term.  Don’t choose investments beyond your risk tolerance.   If you lose your cool and sell at the first sign of trouble, that investment choice probably did you more harm than good.  

#4 Choose well diversified investments to minimize risk

As I’ve discussed many times on this blog, you don’t want to put all of your eggs in one basket.  Investing in a just handful of stocks with your entire nest egg is just way too risky.  If just one of those companies were to go bankrupt, or even just become irrelevant (think Enron, Kodak, or Sears), it could set you back years.  

Instead, it is much better to invest in hundreds, if not thousands, of companies.  How is this possible?  Typically through some type of mutual fund.  Likewise, don’t invest in individual bonds, but rather a bond mutual fund.  

#5 Choose investments with low fees

Fees can kill your overall returns.  Thus, it is important to understand what fees you are paying for the investments you select, and then choose appropriate investments with the lowest fees.  

To better understand the significant impact fees can have on your investments, check out my post The 2% that Will Kill You.

#6 Choose investments that minimize your tax burden

Taxes are the other big killer of your investment returns.   If you can reduce your overall investment tax burden, you can significantly boost your overall returns.   

Most people understand that when you sell an investment (outside of a tax protected account), you are going to owe taxes on the profit (aka capital gain) you receive.  If you hold the investment less than one year, it is usually taxed at your marginal ordinary income tax rate.  If you hold it for longer than one year before you sell it, it is typically taxed at the more favorable long term capital gains rate.  

Based on this, it may seem like a reasonable strategy to just “buy and hold” your investments so you won’t ever owe any taxes on them.  Unfortunately, it’s not that easy and there are other ways your investments are taxed.  Furthermore, it is important to understand that not all investments are taxed the same.  

Actively managed mutual funds are always trying to beat the market.  As a result, they regularly buy hot stocks and sell underperforming stocks.  Selling these underperforming stocks are taxable events.  This means that even though you may not sell your shares of the fund, the fund may have profited from the sale of securities during the year, and come tax time, you will owe taxes on those profits proportional to your shares of the fund.  The more the fund turns over stocks, the more you will owe in taxes.   For this reason, those that do hold shares of actively managed mutual funds typically do so in a tax protected account.   

Index funds, on the other hand, have very little turnover, since they own everything in the index they track.  This significantly reduces any tax burden from fund turnover and is another reason they are so popular.  

Some investments pay you qualified dividends that are taxed at long term capital gains rates (most funds that hold US stocks ), while others pay nonqualified or ordinary dividends that are taxed at ordinary income tax rates (such as bond funds and REITs).   Some investments don’t pay regular dividends and you only owe taxes on the capital gain when you sell the investment.  

Once you have a firm understanding of how various investments are taxed, it can help you not only choose your investments wisely, but also which accounts to hold them in.  Remember, where you hold your investments (tax advantaged vs taxable accounts) can affect your tax bill just as much, if not more, than investment selection.  

A Good Starting Point

OK, keeping these principles in mind, which specific investments should you select when building your portfolio?

While this is not personalized financial advice, I would recommend starting with broad based, well diversified, low cost, passive index funds.  These types of funds check all of the boxes above.  They are easy to understand, there are various types of funds consistent with different financial goals, they are well diversified, they have low fees, and are generally tax efficient.

For these reasons, index funds make up the majority of our investment portfolio and are what I believe is likely the best investment choice for most people.

OK, that sounds great, but which specific index funds should you choose?

Good question.  Personally, I’m a big fan of the The Bogleheads’ Guide to The Three Fund Portfolio approach.  It’s an excellent book that I highly recommend.  To summarize, this portfolio consists of the following three types of funds:

• A US total stock market index fund (or an S&P 500 fund if a total stock market fund is unavailable)
• An international total stock market index fund
• A US total bond market index fund

These three index funds gives you exposure to every publicly traded company in the United States, every publicly traded company throughout the rest of the world, and the United states bond market.  It is very simple to manage and rebalance, extremely well diversified, low cost, and tax efficient.  These three types of funds form the foundation of our investment portfolio.

All the major brokerages, such as Vanguard, Fidelity, and Schwab, offer these types of index funds.  There are both mutual fund versions and ETF versions of the funds.  You may also have institutional versions of these funds available through your employer’s retirement plan.  When making your investment choices, remember that employer sponsored retirement plans (like 401(k)’s and 403(b)’s) may have limited investment options, whereas IRAs and taxable brokerage accounts with major brokerages should offer you the full spectrum of investment choices.  

If you have difficulty finding these types of funds among the list of funds available to you, here are some hints to help you.  First, look at the name of the fund.  Second, look at the summary of the fund or the prospectus to see which index it tracks, and make sure a manager is not actively making decisions about what securities to hold in the fund.  Third, look at the expense ratio.  Index funds have very low expense ratios, typically below 0.10%, or somewhere in that ball park.  Finally, if all else fails, do some google searches on the funds or ask a fee only financial advisor for some help.   

Once you’ve identified which funds you have access to, you can invest in them in proportion to your overall asset allocation.

If choosing your specific funds and rebalancing them over the years is more than you’re interested in doing, then choosing an appropriate target date fund might be the best choice for you.  Just make sure that the target date fund you select holds index funds that meet the aforementioned criteria.  If so, then it could be an excellent choice for you.  You simply make regular contributions to one fund, and let the fund do the rest of the work.  

What about actively managed funds?  Most 401(k) plans have a long list of actively managed funds.  Should you choose one of these?  Maybe.  First and foremost, I would recommend primarily investing in index funds for the reasons already discussed.  However, some 401(k) plans don’t offer a good index fund that tracks the total stock market index or the S&P 500, and only offer actively managed funds.  If these are your only choices, I think it is reasonable to invest in these, at least up to the level of getting your full employer’s match, so you not only get this free money, but also the advantages of investing in a tax protected space.  

What if you want to invest in these funds in addition to index funds?  Some of them may look pretty good and have very high returns historically.  

Most in the FIRE community would highly recommend against this, since over time and after fees, about 90% of actively managed funds don’t beat the market.  They would equate this to committing a cardinal sin of investing, suggesting you are an uninformed or unsophisticated investor destined to lose money.

While I do agree that index funds are overall the best strategy (which is where we invest the majority of our money), I am a little contrarian regarding this kind of dogmatic attitude regarding any other investment besides index funds.  I don’t like blanket statements or assumptions.  

While 90% of actively managed funds may not beat the market, I also see the other side of the coin.  That means there are some, maybe up to 10%, that DO beat the market.  And in my experience, they can significantly beat the market.  These funds are obviously difficult to choose, and in no way does past performance guarantee future results.  However, if you feel like you have access to one or more of these funds with significant upside potential, and want to invest in them with a small portion of your portfolio in tax protected account, I think that is a very reasonable thing to do, so long as you understand the risks. 

What We Do

Since one of my primary goals in writing this blog is to share our journey towards financial independence, I thought it might be helpful (and maybe a little entertaining) to review my thought process in choosing specific investments.  

Please remember, this is not investing advice.  This is what works for us.  I like researching this stuff and our portfolio is a little more complex as a result .  You could simply choose a single target date fund and do just fine.

For simplicity and to keep this post a reasonable length, I’m only going to discuss our publicly traded investments here, specifically funds holding stocks, bonds, and REITs.  

Below is a chart listing the various funds we are invested in.  It is organized by asset class with funds holding primarily US stocks listed first, then international stocks, then bonds, and finally REITs.  I’ve also color coded each line with blue representing passive index funds, and yellow designating actively managed funds.  The expense ratio for each fund is listed as are the returns for the last 1-year, 3-years, 5-years, 10-years, and over the life of the fund.  Finally, I have listed which account we hold each fund in.  

Passive Index Funds

The vast majority of our stock and bond investments are in broad based, well diversified, passively managed, low cost index funds.  For all the reasons discussed above and in other posts, I believe this is the best way to invest and should be the foundation of your portfolio.  We apply this strategy in both our tax advantaged and taxable accounts.  

For our U.S. stock allocation this includes VITPX in my employer sponsored retirement plans with Fidelity, and the ETF version (VTI) in our Roth IRAs and taxable brokerage account with TD Ameritrade.   This is the same VTSAX mutual fund popular in the FIRE community, thanks to J.L. Collins and his book The Simple Path to Wealth, just with a “different wrapper.”

I prefer the total stock market index fund over an S&P 500 index fund because it gives us exposure to the mid cap and small cap stocks that have, at times in the past, outperformed the large cap companies.  However, a total stock market index fund is not available in our Fidelity HSA, so here we invest in the Fidelity S&P 500 index fund, FXAIX.    

For our international index funds, we invest in the Vanguard Total International Stock Index Fund ETF VXUS in our Roth IRAs and taxable account.  A Vanguard total international stock index fund was not available in my employer sponsored retirement plans, so we chose the Fidelity version, FSPSX.   The Fidelity International Index Fund didn’t have the exposure to emerging markets I wanted, so I added the Fidelity Emerging Markets Index Fund, FPADX, to it.  

For our bonds, we invest in the Fidelity U.S. Bond Index Fund, FXNAX, in my 403(b), 457(b) and HSA.  In our Roth IRAs we invest in the Vanguard Total Bond Market Index Fund ETF, BND.  We invest in the Vanguard Tax-Exempt Bond Fund ETF, VTEB, which invests in municipal bonds, in our taxable account to avoid being taxed on the dividends.  

Actively Managed Funds

As I mentioned above, I am not strongly opposed to actively managed funds.  While I think index funds are the best option for most people, and they comprise the majority of our investments, if you have access to really good actively managed funds, I think it is very reasonable to consider including them as a small part of your overall portfolio.  You just have to remember that it is very difficult (more likely speculative) to choose which funds are the “winning funds” and there is never a guarantee they will outperform the market after fees.  

This is the strategy that we have adopted over time.  We invest a small portion of our portfolio in what I believe are very solid actively managed funds that may beat the market (as they have in the past).  We invest no more than 5-10% of contributions to each of these funds.  Also, please note that we only hold these in tax protected accounts since actively managed funds have higher rates of turnover, and thus an increased tax burden if held in a taxable account.

We are invested in five actively managed funds through my employer sponsored retirement plans: four in my 403(b)/457(b) accounts and one in our HSA.  In my opinion, whoever put together the retirement plans for the Mayo Clinic has done, quite frankly, an amazing job in gaining access to funds that have performed very well in the past.  And while past performance is no guarantee of future returns, these funds have continued to do well and justify their higher expense ratios since we’ve been invested in them.  Here is how I came to choose these funds:

Vanguard Primecap Fund Admiral Shares (VPMAX) and T. Rowe Price New Horizons Fund I Class (PRJIX) 

When I first started choosing our own investments (after firing the wealth management service I was auto-enrolled in that was charging me thousands a year and underperforming the market), the financial advisor I was working with (for free through my employer) recommended I consider the Vanguard PRIMECAP Fund (VPMAX) and T.Rowe Price New Horizons Fund (PRJIX).  I was a little skeptical since I knew they were actively managed funds, but I thought it was worth at least taking a look.  As I researched them and the companies they invest in, I learned that these funds were now closed to general investors and you couldn’t get into them unless it was through an employer sponsored retirement plan or other special circumstance.  Many investors on the Bogleheads’ forum praised these funds and said they would invest in them if they could.  Also, the returns had historically beaten the market quite significantly.  

So, understanding there was some risk, I thought what the heck and allocated a portion of our contributions to these funds.  Needless to say, I’ve been happy with returns so far, especially PRJIX.  Who wouldn’t be happy with a 48% return last year and and average annual return of 28% over the last 5 years that we’ve been invested in it.  

American Funds The Growth Fund of America Class R-6 (RGAGX)

I was pitched this American Funds investment by our Northwestern mutual salesman/financial planner before we parted ways.  American Funds is a huge, actively managed mutual fund company and they have been around for decades.  He said they had consistently beaten the market and I should consider adding them to my portfolio (of course he would receive a commission).  As I researched this investment and the underlying companies, I learned that these funds had indeed consistently beat the market in the past.  However, they charge you a 5.75% front load when you invest and an average expense ratio around 0.60% each year.  While the past returns were tempting, I felt that was way too much to pay in expenses.  

With this experience in mind, I later discovered that the institutional class of this investment was available in my employer sponsored retirement plans where I could invest in the same portfolio of underlying companies, WITHOUT the 5.75% front load and for a better expense ratio of 0.30%.  Needless to say, I jumped on that opportunity.  

T.Rowe Price Blue Chip Growth Fund I (TBCIX) 

The T.Rowe Price Blue Chip Growth Fund is an actively managed fund I found I had access to in our HSA account with Fidelity.  It has consistently beaten the market . . . by a lot, and invests in what are in my opinion solid companies.  With a similar strategy in mind to my 403(b) and 457(b) accounts, I allocated a small portion of our HSA contributions to this fund. 

T. Rowe Price International Discovery Fund (TIDDX)

Most investors know that international stocks have lagged US stocks for many years now.  While that may not always be the case, I admit it is difficult to continue allocating a significant portion of your portfolio to an asset class that seems to always fall behind your home country’s stocks.  As I was perusing the available international stock options in my 403(b) plan, I came across the T. Rowe Price International Discovery Fund.  Over the years it has crushed the returns from the international index funds. But it has a steep price. The expense ratio is a whopping 1.07%.  While I would never allocate a large portion of our portfolio to a fund with this high of an expense ratio, am I willing to allocate 5% of our contributions to it to boost our returns from international stocks?  Absolutely.  And you can see it has treated us well thus far if you compare its returns to the passive international index funds.  

Do you need to invest in actively managed funds to be successful?  Definitely not.  You could invest in a target date fund or just in index funds and do very well (maybe even better).  But I don’t think you are a foolish investor if you have some exposure to them.  

I will be the first to admit that critics of investing in actively managed funds have some valid points.  Here are a few, as well as my counter argument:

Past performance does not guarantee future results

Many say it is a fool’s game to base investment decisions on past performance, as there is no way to predict how these funds will do in the future.  While I understand this to be true, there is really little else, other than researching the underlying companies, that we have to base decisions on and I believe it does give us some valuable insight into the fund.  I fully understand that these funds could crash and burn and underperform the market.  And that is why we only invest a small percentage of our portfolio with them.  But there is certainly high upside as well, and I am comfortable with this risk/reward profile.  

Market overlap

Why invest in these actively managed funds if you are already invested in these companies through your index funds that hold all the publicly traded companies already?  While it is true that you already hold these companies through your index funds, actively managed funds are theoretically weeding out the dogs and overweighting potential winners, thereby boosting your returns.  

Higher fees

Actively managed funds certainly have higher fees.  However, if we are making more money than the market after fees, then I am absolutely fine with that (and so is our net worth).  Again, this is a risk I am willing to take with a small portion of our portfolio.  

At the end of the day, this is what we are comfortable with, and for now these funds are outperforming the market.  Could this change in 2021?  Absolutely.  And that is something you have to be okay with if you are going to take this approach.  

Alternative Assets

Remember, you DO NOT have to invest in alternative assets to be a successful investor and become financially independent.  So if that doesn’t interest you, no worries, stick to traditional asset classes.  

However, for reasons I’ve discussed in other posts I am a big fan of real estate.  As part of our real estate exposure, we have decided to invest in a REIT index fund.  Specifically, this is the Vanguard Real Estate Index Fund.  We invest in the institutional version VGSNX through my 403(b) and 457(b), and VNQ in our Roth IRAs.  I’ll write more about our other non-publicly traded real estate investments in future posts. 

Conclusion

Today we’ve discussed choosing specific investments for your portfolio.  While this isn’t investing advice, hopefully a review of these concepts and the discussion of our personal investments will help you make educated decisions when choosing your own investments.

Here are some take home points to consider:

• Make sure you understand basic financial terms before researching investments
• Choose investments that:
  • You understand
  • Are consistent with your financial goals
  • You can stick with long term
  • Are well diversified
  • Have low fees
  • Are tax efficient
• Index funds are the best choice for most investors and should form the foundation of your portfolio
• Target date funds are an excellent choice for hands off investors
• Actively managed funds may be reasonable with a small portion of your portfolio, but aren’t necessary for long term success

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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