Building a personalized investment portfolio using mutual funds can be as simple or complex as you want. We prefer the simple route. Learn more about building a mutual fund portfolio in this fourth chapter of our Beginner’s Guide to Mutual Funds.
In this chapter:
- How can I beat the market?
- What asset classes should I include in my portfolio?
- Which portfolio model is best for me?
- What are retirement target date funds, and are they right for me?
According to our philosophy here at Fund Reference, this is the wrong question to be asking. You can attempt to beat the market, and you may very well have success at doing so — in the short term. But the fact is that it is very difficult to beat the market consistently over a long period.
Consider this example: in 1970, there were 355 equity mutual funds. By 2005, only 132 of those funds had survived. Of those 132, 60 of them underperformed the market; 48 were roughly market equivalent (within +/- 1 percent of the market); and only 24 outperformed the market by 1 percent or more. (Source: The Little Book of Common Sense Investing by John C. Bogle.) Basically, only one out of every 14 professional mutual fund managers was able to beat the market over this 35-year period.
Those who do beat the market are able to do so only by taking on additional risk. In the short term, this may work, possibly for a year or two, perhaps longer. But the longer the time period, the less likely it is that a high-risk strategy will end up outperforming the market.
The main killers of actual net portfolio returns are high fees and behavioral mistakes. You can beat 90 percent of all other investors simply by holding a balanced portfolio that has low fees and by avoiding behavioral mistakes. Buying and holding low-cost index funds for the long term is a winning strategy not because it beats the market, but because it merely replicates the market.
In buying an index fund that replicates the market, you are diversifying your portfolio — thereby eliminating unsystematic risk — while keeping costs low (as index funds typically have much lower expense ratios than do actively managed funds). By holding index funds for the long term, you are able to avoid behavioral mistakes, which can often devastate returns. You won’t beat the market with this strategy, but you will outperform the vast majority of those who pay for actively managed funds and/or trade stocks regularly.
There are several asset classes to consider when constructing your portfolio, including stocks and bonds, as well as more exotic asset classes such as alternatives, commodities, currencies, and real estate. A portfolio composed entirely of stocks and bonds is sufficient for the vast majority of investors. The other asset classes are inherently speculative in nature and are not recommended for most investors.
How you construct your portfolio should largely be a factor of your risk tolerance. In fact, determining your risk tolerance and asset allocation is one of the biggest investing decisions you can make. The most popular portfolio models are all pretty similar, and are constructed entirely of stocks and bonds. It bears repeating that the more exotic asset classes are unnecessary for the vast majority of investors.
Some of the most common portfolio models are:
- 60/40 Portfolio: This is a conservative portfolio, with 60 percent in equities and 40 percent in bonds. It is suitable for those who are approaching retirement or those with low risk tolerance. You could actually accomplish this portfolio by investing in just two low-cost index funds from Vanguard — Vanguard Total Bond Market Index Fund (VBTLX) and Vanguard Total Stock Market Index Fund (VTSAX). If you wanted some international exposure, you could do VBTLX and Vanguard Total World Stock Index Fund (VTWSX).
- Age-in-Bonds Portfolio: Using this model, you would subtract your age from 100. This is the percentage that you allocate to equities. The remainder (your age) is allocated to bonds. Each year you rebalance, you shift your portfolio away from equities and into bonds, becoming more conservative as you age. This portfolio can also be accomplished using the aforementioned VBTLX and either VTSAX or VTWSX.
- Three-Fund Portfolio: A three-fund portfolio has exposure to bonds, U.S. equities, and international equities by investing in only three funds, usually allocated equally, resulting in a split of roughly 67 percent equities and 33 percent bonds. Using Vanguard funds, you can put together your own three-fund portfolio with the aforementioned VBTLX bond fund, VTSAX U.S. stock fund, and Vanguard Total International Stock Fund (VTIAX).
Our advice is to pick one you like and can stick to over the long run. If you can keep costs low and avoid making major behavioral mistakes, you’ll beat most other investors.
Target funds are mutli-asset mutual funds, whose weightings in stocks and bonds change automatically over time. It’s the mutual fund industry’s version of set-it-and-forget-it. An investor who does not want to be bothered with maintaining the appropriate assets class weightings over the course of her investment horizon can do pretty well for herself simply by contributing regularly to a target date fund. The glide path of Vanguard’s target date funds illustrated below shows how the shift from stocks to bonds happens gradually as the investor ages.
To invest in a target retirement date fund, you first select the approximate year that you think you will retire in. If you expect to retire in 2045, you should find a 2045 retirement date fund to invest in. When you first invest in 2015 (30 years from retirement), the fund may have a mix of roughly 90 percent stocks and 10 percent bonds. Over time, the fund will gradually shift out of stocks and into bonds. By 2045, the fund may have a 50/50 split. As the years go by after retirement (years after 2045 in this example), the fund will continue to shift away from stocks for several years and eventually settle at a 30/70 split. This is roughly what the Vanguard retirement target date funds do, but the glide paths of other issuers’ retirement target date funds may differ.
This concludes The Beginner’s Guide to Mutual Funds. If you missed any of our previous chapters, please refer to the table of contents below.