In the previous article, we presented the basic, master portfolio, which, like a master dough recipe or a master sauce, can be adjusted to meet your particular investing needed. Today we’re going to talk about what makes the master portfolio work.
(This is part of a series of articles to teach those who are new to investing how to invest. To find other articles in this series, choose “Beginner Investing Class” under “Investing” in the menu at the top of the page. If you have questions or you’d like a topic to be covered, please leave a comment at the bottom of the post.)
Once again, the master portfolio is composed as follows:
20% General Large-Cap US Stock Index Fund
20% General Small-Cap US Stock Index Fund
20% International Stock Index Fund
20% General US Bond Index Fund
20% US Real-Estate Investment Trust (REIT) Fund
The first thing that you should notice is that the portfolio is invested in mutual funds. Mutual funds are investments where people pool their money together and then have a fund manager invest the money for them. The reason that we choose mutual funds is that it a) makes it easy for you, the investor, and 2) by spreading out your money to several different companies, we eliminate the risk of a big loss should one company have a bad year. The first advantage should be obvious – by paying a professional manager to invest the money for you, you just need to send in a check and wait. You don’t need to research stocks, learn how to buy stocks, learn when to buy stocks, learn the lingo needed to place a trade, and keep track of your investments in a bunch of different companies for taxes. You just pick up the phone or go to a website and say you’d like to put $1,000 into the Vanguard S&P 500 fund and you’re done.
The second reason may not be as obvious, but it is easy to understand if you think about it. Let’s say that you were investing in the restaurants in your town. Lets first say that you picked one restaurant to start with and put all of your money into it. As you know, restaurants come and go all of the time because the food isn’t good, the owners don’t know how to manage the books, there is too much competition, or a variety of other issues. Even if you pick one that is doing well and has customers coming out the doors, the husband and wife team who run it might get divorced and end up closing anyway. The partners might have a fight. One of the main partners might get married and his/her spouse may not want the restaurant life. There are all sorts of things that could go wrong. If you buy single investments, the same thing can happen. First of all, it is hard to pick the successful companies out of a sea of possibilities. Secondly, even if you do, an issue with the management, a lawsuit, or just a misread of the market by the CEO could scuttle your investment.
Let’s now say that you invest a little bit in every restaurant in your city. While some will fail, on average, assuming people keep going out to eat, restaurants become more efficient and are able to lower their costs, and the population keeps growing, the restaurants that are really successful will more than make up for the ones that fail or just languish without really growing. You would still make money overall. In fact, if you analyzed how many fail and the average return for the restaurants that stay open, you could almost predict your return.
You would also be insulated from an issue at one particular restaurant like a divorce or a broken partnership because even if one fails and disappears completely, it will only take out 1% of your portfolio, not 100%. Investing in mutual funds is like investing in every restaurant. This is called diversification and is a way to eliminate the risk particular to specific companies like corporate fraud or a PR miscue. It also frees you from the risk of simply choosing the wrong company and not having it fail outright, but maybe just not do that great. There are a lot of companies that just flounder for years for the few that grow like crazy and become the next Apple or Amazon. You’ll always have at least some money in the best company in the market.
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Let’s diversify further
The next thing to notice is that the master portfolio is spread out among five different mutual funds. These particular mutual funds all invest in different things. The large-cap fund invests in big US stocks, the small-cap fund invests in small US companies, the international stock fund invests outside of the United States, the bond fund makes loans to companies and government entities, and the REIT fund buys trusts that buy real estate.
If you were to just buy five funds at random, you could end up investing more of your money in the same companies than you intended by accident. For example, if you bought an S&P500 fund, a NASDAQ fund, a large-cap growth fund, and a balanced large-cap US stock fund, you would have about 10% of your money in Apple Computer. This is because all of these funds invest in Apple Computer and it is a dominant part of the market in which these types of funds invest. If there were a big issue at Apple, you could lose 10% of your money.
A large-cap fund and a small-cap fund will own none of the same stocks. They invest in totally different parts of the market. A stock and bond fund don’t even invest in the same types of assets. One buys ownership in companies (stocks) and the other buys loans to companies (bonds). Stocks and bonds can be hurt by the same events, however (such as interest rate increases), so adding real-estate through REITs diversified your investments further. While it can happen that stocks, and REITs decline at the same time (see 2009), they usually are not correlated at all. Basically, no matter what part of the market is doing well at any given time, you’ll be invested in it.
Now granted, this also means that you’ll be invested in the worst part of the market at any given time, which you might think would cause you to break even. This would be true if the good and the bad went up and down by equal amounts, however, all of these investments–US stocks, International stocks, bonds, and real-estate–are always growing over time. Stocks will grow faster than bonds over long periods of time, so your stock fund may double every six to eight years where your bond fund will only double every eight to twelve years, but they will both go up if you hold them long enough.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.