"By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals." --Warren Buffet, 1993
This is a guide to investing in mutual funds. It is aimed at beginners, and describes a strategy that is sophisticated but not difficult. It will explain how to construct a portfolio of funds so that you can choose (if you wish) to increase the types of risk that will increase your return, and avoid those risks that don't. You can thus lower the risk (volatility) and/or increase the return of your overall portfolio.
Although there are brief explanations of the reasoning behind each point, this guide omits any discussion of the evidence for this approach. Interested readers may consult the references given at the end.
This guide contains five sections:
Most of the risk and return of your portfolio can be predicted by knowing what asset classes it contains -- what percentage stocks and bonds, and what percentage of the various subtypes of stocks. You should therefore focus on choosing funds that hold certain asset classes, and hold those funds in certain proportions. The second part of this article describes how to do this.
Very little portfolio performance is determined by stock picking (picking good individual stocks to hold) or market timing (buying and selling at the right time). You can do a satisfactory job of these tasks as follows.
Most mutual funds are actively managed, which means their managers try to pick better than average stocks, to try to outperform an index of representative stocks in their category. Unfortunately half of them will underperform the average, by definition. There are also index funds that reliably replicate the performance of those categories. Choose the index funds instead of the actively managed funds.
Invest money when you get it. If you have a regular income, invest equal amounts of it regularly. This is called Dollar Cost Averaging, and will cause you to buy more stock when it's cheap and less stock when it's expensive. But if you have a lump sum to invest, invest it all right away. The compounded growth over time in the market will usually outweigh any risk of losses from buying at a high point in the market.
Suppose you earn 8% from your investments. After inflation that's about 6%. If you or your funds trade a lot, taxes can take another 2%. If you hold funds with average expenses, those take another 2%. Now you have 2% left, a mere 1/4 of your original return. Thus it's worth reducing taxes and expenses where you can.
Again, this can be done by choosing index funds over actively managed funds. Active funds that research and trade stocks have higher expenses and generate more taxable transactions than passive funds that don't. Active funds charge 1-3% for expenses; passive funds usually charge 0.1-0.8%. If active funds could consistently beat the index by 3% to cover their expenses and additional taxes, they might be worth considering. But the average active fund obtains the index fund performance exactly, by definition. So choose passive funds (index funds are generally passive funds, and vice versa).
Avoid paying any additional fees, such as front-end or back-end loads or wrap account / fund-of-fund fees. Also do not pay a percentage of your assets for investment advice. If you want further investment advice, pay a fee-only advisor who charges an hourly rate.
On any given day, an index fund will have average performance among funds in its asset class. Average sounds mediocre, but it's the return you could expect from picking a fund at random. Unfortunately there is no better way to pick a fund. It's almost impossible to pick an outperforming mutual fund ahead of time, because high returns usually do not persist, and you need long time periods to distinguish skill from random chance. So picking an index fund will get you the expected performance of any active fund in that asset class (on a given day). Moreover, after accounting for costs, the index will beat the average return of an active fund by about 2%.
Besides its slightly higher returns, choosing an index fund is also less risky than choosing an active fund. Over a long time period, active funds tend to eventually do one of three things:
Extremely few funds do (3), but many funds do (1). So by choosing an active fund, you are risking worse-than-average performance. But you are not being rewarded for this risk (since on average you get slightly lower performance than the index fund, due to expenses). So it's better to not expose yourself to this risk, and just buy the cheap, average performance. There are other types of risk that will increase your return, namely the risks involved in asset allocation.
Different asset classes, such as stocks and bonds, grow in value at different rates and with different levels of volatility. They also fluctuate in value out of sync with each other (they are "uncorrelated"). When one decreases in value, the others may increase in value. So owning different asset classes smooths out the performance of the portfolio as a whole. In other words, you get lower risk for the same return, or higher return for the same risk.
The usual approach is to allocate a fixed proportion of your portfolio to each asset class. If the assets fluctuate in value and differ very much from your target proportions, you can "rebalance" by buying or selling a little of each to bring them back to their target proportion. Since this involves selling high and buying low, it will slightly increase your performance. You don't need to do this more than once a year, though.
Another approach is "tactical asset allocation" -- changing your asset allocation based on predictions of how various asset classes will perform. This is a form of market timing, and as such it adds risk without a reliably increased return. There are no methods to persistently increase your return this way, other than regular rebalancing.
When choosing asset classes, there are three different factors (or sources of risk) that affect the return of your portfolio: market exposure, style (growth and value), and size. (Each is described below.) For each factor, you can divide the market into two uncorrelated asset classes, one of which is more volatile and has higher long-run return. You can choose to expose your portfolio to more risk for more return, by over-emphasizing the more volatile of the two classes.
Most of the risk and return of your portfolio can be explained by referring to these three factors. Other sources of volatility or risk (such as individual stock selection or market timing) are not generally accompanied by increased return -- sometimes they increase return, sometimes they decrease return.
The factors are explained below in order of decreasing importance. Each successive factor introduces a new division of the portfolio, doubling the number of asset classes. If you feel the resulting portfolio is getting too complicated at any stage, you can stop there.
The two main asset classes are stocks and bonds. Both generate income, and both can gain or lose value. (Eg. a bond loses value when prevailing interest rates rise.) Stocks produce lower income streams and are more volatile than bonds. However, stocks grow much more over time -- historically 6% for stocks vs 2% for bonds.
When deciding how much of your portfolio to allocate to bonds, anywhere between 20% and 80% is reasonable. More bonds will make your portfolio less volatile and will lower its return. A common rule of thumb is to make the percentage of your portfolio in bonds equal to your age. Eg. a 20-year old would hold 20% bonds; a 60-year old would hold 60% bonds. That means your portfolio will be risky and have high growth potential when you're young and have lots of time for your investments to grow and recover from losses. The portfolio will get safer as you approach retirement.
However, you should decide how much risk you're comfortable with, and accept the corresponding level of returns. Below is a chart comparing bond/stock mixes to the size of the largest short-term loss you might experience during the lifetime of the portfolio.
| % lost | % bonds |
|---|---|
| 0 | 90 |
| 5 | 80 |
| 10 | 70 |
| 15 | 60 |
| 20 | 50 |
| 25 | 40 |
| 30 | 30 |
| 35 | 20 |
For the bond part of your portfolio, choose a short term bond fund. Longer term bonds give slightly more interest, but not enough to justify the extra volatility. The bonds should also be in your home currency (eg. Canadians should choose Canadian bonds).
For the stock portion of your portfolio, a first step would be to choose a "total market" USA index fund.
Companies have a certain fundamental value based on the dividends they pay, the earnings they declare, the book value of their assets, etc. Based on that underlying value, the per-share price to own part of that company can be cheap or expensive. Companies that everybody thinks are (or will be) valuable have expensive shares; people are willing to pay more for those. These are called growth stocks, and are characterized by high price/earnings (P/E) ratios. Companies with poor or merely boring prospects have cheap shares. These are called value stocks, and are characterized by low P/E or price/book value (P/B) ratios.
Value stocks tend to be more volatile (many of them fail). They also tend to grow more in the long term, perhaps because of their riskiness or cheapness.
You get high exposure to growth stocks by owning a total market index (often called a "blend" of growth and value). These indices are dominated by growth stocks, since growth stocks have high share prices and the composition of most stock indices is determined by market capitilization (total price of all shares). To increase exposure to value stocks, there are value index funds. Allocating up to 50% of the stock portion of your portfolio to value stocks is reasonable.
Companies are ranked as big or small according to their market capitalization (total price of all shares). Small stocks tend to be more volatile and have higher long term growth. Large stocks dominate the indices. There are "large cap" and "small cap" index funds. Allocating up to 50% of the stock portion of your portfolio to small stocks is reasonable.
Combining the maximum recommendation for growth/value and large/small ratios, you would have 25% large growth, 25% small growth, 25% large value, 25% small value.
A final way to split up your portfolio is by adding international stocks.
The American stock market accounts for half of the world stock market capitalization. The stock markets of the rest of the world can be accessed through "international" funds. International stocks tend to be more volatile, but they may not have higher return. However, their correlation with American stock markets is still low enough to make them a valuable addition to your portfolio.
There is also probably an index fund for your country, in your currency. On the one hand, investing in your country's stock market is good because it increases your exposure to your own currency and economy (which you will likely use and participate in when you retire). On the other hand, the stock market is correlated with the performance of businesses in your country. If the economy slows down, you may lose your job and your retirement savings at the same time. So investing in your home country's stock market is a matter of preference (or trying to guess whether the market will do well).
It's reasonable to put 20-40% of your stock holdings into international stocks. If your home country's stock market is well regulated, you could also put 20% in it. The bulk of your portfolio (40+%) will go into the American stock market.
The International stock indices cover only developed regions, namely Europe, UK, Japan, Australia. Developing countries such as China, India, Russia, Brazil are covered by "emerging markets" funds. These are more volatile and may or may not have higher long term growth. Putting a small amount of your international holdings in emerging markets is not a bad idea, but it's not clear that you get additional return to compensate for the extra risk.
You can buy mutual funds directly from a mutual fund company, who will hold them in an account for you. Mutual funds (should) cost nothing to buy or sell; avoid those that do. In the USA, buy Vanguard funds. In Canada, there are no low-expense mutual funds that provide growth/value and large/small funds. Use a low-cost index fund for the asset classes where they exist, and mix and match other funds for the rest. (See the example portfolio below.)
A low cost alternative to traditional mutual funds is to choose Exchange Traded Funds. ETFs are like mutual funds that trade on the stock market. Thus you can buy them in any country where you can buy American stocks. They have low expenses (as low as Vanguard) and low transaction costs (and thus low taxes). Unfortunately you have to pay normal brokerage commissions to buy and sell them like stocks. Because of this, you should only buy or sell them once a year. During the rest of the year, invest money in a balanced index fund, then re-invest it in ETFs at the end of the year.
If you have enough money to invest, the lower ongoing expenses of ETFs will make up for the brokerage commissions. $50,000 is generally enough to justify ETFs. If you are starting with less than this, use mutual funds for now. In the USA, it makes no sense to use ETFs, since Vanguard funds have roughly the same low fees, but no brokerage comissions are necessary.
There are several companies that produce ETFs. Barclays is large and well-respected, and its Ishares products ('Canadian <http://www.ishares.ca>'_ and 'USA <http://www.ishares.com>'_) can provide most of the asset classes you need.
To buy ETFs you will need to open an account with a broker. Do not use a full-service broker. He will charge $150 per trade. In return, the broker will
Instead open an account at a discount broker. In Canada, each bank has a decent discount broker, and E*Trade is also good. Discount brokers will charge $10-$30 dollars per trade. (Before opening an account, check the broker's commission tables.) You have to do the trades yourself (generally over the telephone or Internet), but this is not difficult and should be done only once a year anyways.
An RRSP is a Canadian tax shelter. It is merely a designated account with a broker, mutual fund dealer, or bank. You can have more than one, with different institutions. You don't have to pay income tax on the money you put into the RRSP, nor do you pay income tax on the investments within. When you withdraw money from the account (usually at retirement), you are taxed as if it is normal income. This is a higher rate than the capital gains or dividend tax rate, but you delay paying the tax for so long that it is generally worth it. You are limited to putting 18% of your income in an RRSP. If you have more than that to invest, put the bonds in the RRSP first, as they are taxed at the full income rate anyways.
Hopefully you didn't just skip to this section.
| % | % | Market | Style | Size | Region | Symbol | MER | Description |
|---|---|---|---|---|---|---|---|---|
| 40% | Bonds | Canada | 0.91% | TD Candian Bond Index Fund | ||||
| 60% | 20% | Stocks | Growth | Large | USA | 0.55% | TD US Index Fund | |
| 20% | Int | 1.41% | TD International Index Fund | |||||
| 10% | Canada | 0.88% | TD Canadian Index Fund | |||||
| 10% | Small | USA | 2.52% | TD US Small-Cap Equity Fund | ||||
| 10% | Int | 2.73% | CIBC International Small Companies Fund | |||||
| 10% | Value | Large | USA | 2.52% | TD US Large-Cap Value Fund | |||
| 10% | Int | 2.00% | Fidelity International Value Fund | |||||
| 10% | Canada | 2.28% | TD Candian Value Fund |
Notes:
| % | % | Market | Style | Size | Region | Ticker | MER | Description |
|---|---|---|---|---|---|---|---|---|
| 40% | Bonds | Canada | XSB | 0.25% | Short-term Canadian Bond | |||
| 60% | 6% | Stocks | Growth | Large | USA | IWB | 0.15% | Russell 1000 |
| 6% | Int | EFA | 0.35% | EAFE (Europe Australia Far East) | ||||
| 6% | Canada | XIC | 0.25% | S&P/TSX Capped | ||||
| 6% | Small | USA | IWM | 0.20% | Russell 2000 | |||
| 6% | Int | EEM | 0.75% | Emerging Markets | ||||
| 6% | Value | Large | USA | IWD | 0.20% | Russell 1000 Value | ||
| 6% | Int | EFV | 0.40% | EAFE Value | ||||
| 6% | Canada | XDV | 0.50% | Dow Jones Canadian Select Dividend | ||||
| 6% | Small | USA | IWN | 0.25% | Russell 2000 Value | |||
| 6% | Int | DLS | 0.58% | WisdomTree International SmallCap Dividend |
Notes:
The table of % lost and % bonds was adapted without permission from a table in The Four Pillars Of Investment.