I think this is the most frequent question I hear about personal finances. What should I buy into my portfolio? This was a question that I contemplated for years.
I stopped using that approach when I was in medical school and got too busy to pay attention to the stock market. It wasn’t until my residency (my training after finishing medical school) that I discovered more reasonable investment approaches. For this, I owe pioneers and authors like John Bogle (the bogleheads forum), Dr. James Dahle (White Coat Investor). I think the biggest take away for me over the years is that personal wealth does not accumulate overnight. It takes time, patience and a lot of discipline. If you are looking for short-term profit, my blog is not going to help you.
There are two main types of investment strategies today: passive investment and active investment.
- Passive investment refers to an investment strategy where you buy index funds to replicate a benchmark growth, such as the US stock market.
- Active management refers to a strategy where you pick specific stocks and try to time the market to beat a benchmark, such as US stock market.
I believe in long term passive investment in low cost index funds.
Since the beginning of stock trading people have tirelessly engaged in active investments believing that they, above everyone else, will be able to pick the winning stocks that will make them rich (and famous). History has proven again and again that active management is futile in its efforts to beat the market.Warren Buffett is one of the few individuals that has done so, but even Warren Buffett knows that passive investment is a better strategy than active management. In 2007, Mr. Buffett made what’s called the “one million dollar bet” with a hedge funder. Buffet bet that he would pick one index fund and it will outperform any active management mutual fund of the hedge funder’s choosing. In 2017, Mr Buffett’s choice of Vanguard S&P 500 has accrued over $854,000 while the hedge funder’s choices only earned $220,000 at best. Mr. Buffett was able to confidently make such a bet not only because he knew the evidence is stacked in favor of passive investment.
Here are my rules of thumb when it comes picking your investments:
- Passive investment beats active investment. Passive investment is the holy grail of personal financial management. My goal is achieving maximal return with minimal effort. We all know that stock markets move up and down constantly and unpredictably. Despite its ups and downs, if you study the long term pattern, the US market consistently achieves, on average, over 7% gain per year. In other words, if you invest in the whole US stock market over a long time (i.e. decades), you are almost guaranteed at least 7% per year, compounded growth every year. I personally have no individual stocks in my portfolio. Low cost stock funds and bond index funds are the only types of investments I keep in my portfolio.
- Diversification reduces risks. When the market takes a dive (it does periodically), you want to have some portion of your portfolio to carry assets that move against the market to reduce your losses. There are several types of assets that are considered adequate diversifications, including various bonds, precious metals, real estate, etc. These are assets that have demonstrated small to even negative correlations to the movements of stock markets during past economic downturns. Obviously, the degree of market correlation varies among these assets. And the correlation can sometimes depend on the reason of market downturn. For example, 2009-2011 housing bubble saw strong time correlation between the real estate crash and stock market crash. If you only invested in real estate and stock market, your portfolio by 2011 probably looked pretty bleak.
- Higher risk investment yields higher returns:
- Value funds yield higher returns than growth funds. A value fund is a collection of stocks that is deemed “undervalued.” They tend to pay higher dividends. A growth fund is a collection of growth stocks which doesn’t often pay dividends as the company often chose to reinvest retained earnings. Growth stocks rely on the company’s success for returns on their investment. High tech companies often offer growth stocks. There is a third type of stock called blend stock which is a blend of value and growth.
- Small cap funds yield higher returns than large cap funds. Small cap describes an index fund’s market capitalization. It’s somewhat a relative term, defined variably by different brokerages. Small caps are usually issued by companies with market capitalization between $300mil and $2bil. Large cap funds are funds with market capitalization above $10bil. These are companies like Apple, Exxon-Mobile, Wal-mart, etc.
- Minimize your fees: Minimizing effort and minimizing expenses are two major pillars to passive investment. You want your portfolio to be simple to manage so it doesn’t become a second job. You want to pick a brokerage with the lowest fees. I have my 401k with Charles Schwab, my 403b with Fidelity, and my taxable and IRAs with Vanguard. The first two institutions were picked by my employers. I had no say in the investment brokerage. They served me well over the years. Their cost, however, would be considered outrageous to people on Bogleheads forum if you ever find your way there out of curiosity (it is an incredible personal financial management resource). Vanguard is by far the lowest cost option and is my recommended brokerage, if you are managing your own retirement investments.
What do you think? Any other investment rules you follow when it comes to your portfolio building? What do you put in your portfolio? I will have some portfolio suggestions in part 2.
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