The New Coffeehouse Investor

ONCE YOU REMOVE YOURSELF FROM WALL STREET’S complete and total obsession with trying to beat the stock market average and accept the fact that approximating the stock market average is a rather sophisticated approach to the whole thing, building a successful common-stock portfolio becomes an immensely gratifying experience.

This is important, because even though we all have that innate creativity that yearns to build something and watch it grow—whether it be a project at work, a child, or a garden—we also have a tendency to throw up our hands in despair and call in the experts when faced with a task that those same experts have labeled “too complicated for you.”

Diversification simply means making sure your stock market investments are aligned with the collective creativity of our country and are not subject to the more volatile ups and downs of specific stocks, industries, trends, or business cycles. That’s not to say fortunes haven’t been made in one-stock portfolios, because they have. Just ask Bill. No, not me.

It is probably very exciting to have your entire portfolio invested in one stock that goes up and up forever, although I wouldn’t know because it has never happened to me. But the rewards of owning a one-stock portfolio need to be weighed against the risk of having that same one-stock portfolio go down and down forever as you approach retirement.

The more your portfolio is diversified in many different companies in many different industries, the less your financial goal is dependent on your or anyone else’s ability to successfully pick individual stocks, industries, or trends—something mutual fund managers have proven is not easily done.

That’s why indexing your portfolio makes so much sense. Not only does it give you the ultimate in diversification by owning the widest selection of companies in the maximum number of industries, but it simplifies your selection process of narrowing down fifteen thousand funds and seven thousand stocks to a couple of sensible mutual funds.

The simplest approach to diversifying your stock market investments is to invest in one index fund that represents the entire stock market. The problem with having your entire common stock portfolio invested in one “entire stock market” index fund is that eventually, at some backyard barbecue, you will cross paths with a Wall Streeter who, upon learning that your entire portfolio consists of only one mutual fund, will argue that you are way underdiversified and will pay for that mistake the next time the stock market drops.

HOWEVER . . . even though an entire-stock-market index fund is a simple, smart way to invest—especially for those who currently have twelve different mutual funds and eight different stock positions and no earthly idea how these investments are performing, much less how they all fit together—we can combine this thing called diversification with our index-fund approach and divide our stock holdings among three groups:

large company stocks,
small company stocks,
and international stocks

and build a common-stock portfolio using three index funds that represent each of these three groups of common stocks.

The advantage to investing in three separate index funds instead of one entire-stock-market index fund is that it takes this diversification thing one step further by introducing other dimensions of the market into your portfolio that move dissimilarly to large company stocks in the short run, if not the long run. And it allows you to construct a personalized portfolio to match your temperament and investment time horizon.

For instance, investors who have a longer time horizon and are able emotionally to accept increased volatility can add to their holdings in small-cap stocks and thus provide themselves with an opportunity for increased returns over time beyond what large-company stocks offer. But for investors with a more conservative demeanor, or those who are nearing a financial goal, owning more large-company stocks should be considered, as these stocks have traditionally been less volatile than small-company stocks and have provided more income from dividends.

In addition to choosing a three-index-fund approach, you can take this thing called diversification one step further by adding three more dimensions of the market to your portfolio—value, small value, and REITS (real estate investment trusts)—and build an indexed portfolio utilizing these different dimensions of the market. Instead of owning three index funds, your common-stock portfolio would now consist of six index funds:

large-company,
large-company value,
small-company,
small-company value,
international,
and REITS.

Keep in mind that if you choose to add value and growth index funds to your portfolio, you are doing nothing more than fine-tuning an already good thing. It simply takes this thing we’re talking about—diversification—one (small) step further. (For help in selecting index funds among these five groups, turn to the appendix, which lists index funds by categories.)

In chapter 2 we learned the importance of annually rebalancing your investment portfolio among stocks, bonds, and cash to make sure your investments are in line with the type (and amount) of investment risk you want to maintain. The same rebalancing concept holds true for the common-stock portion of your portfolio. Whether the common-stock portion of your portfolio is aggressive or conservative, the most important factor when diversifying is to adhere to this asset allocation strategy, because when you stick to your strategy and rebalance your assets at year-end, buy and sell decisions are no longer arbitrary but are instead objectively carried out according to your predetermined plan. The result: a portfolio that has less volatility without sacrificing performance.

Sometimes it is emotionally difficult to reallocate assets away from the class that is doing well (in this case, large-company stocks) and invest them in the class that has underperformed. But those who neglect this important aspect of portfolio diversification often find that when the tide eventually turns (as it always does), they are stuck with an excessively large, underperforming asset class.

It’s easy to rebalance a portfolio in a tax-deferred retirement account because you are not subject to a capital gains tax on profits taken. This means you can sell stock as part of your rebalancing plan and not have to pay taxes on any profits from that sale—those profits are reinvested within your tax-deferred account.

If instead you have a regular (taxable) account, you need to consider the impact a capital gains tax will have on your rebalancing efforts. In this case, instead of selling and buying to rebalance your account as we did in the above example (again, because selling stock in a taxable account might result in capital gains taxes), it might make sense to leave existing money where it is and direct new money into that portion of your portfolio that is underrepresented according to your desired allocation strategy. Before you make any portfolio changes that could result in a significant tax liability, it’s always best to consult with your accountant or tax attorney.

The task of building an indexed common stock portfolio is pretty straightforward. Unfortunately, many qualified retirement plans, including 401(k)s, still do not include index funds. For those investors whose only investment in common stocks is through retirement plans that do not include index funds, choices are not as simple.

In my opinion, any company that doesn’t provide employees an opportunity to invest in index funds should be held accountable to its employees to the extent that the company plan’s managed mutual funds underperform their respective stock market indices.

Plan A for solving this problem is to go to your employers and encourage them to include index funds in their choice of funds (which most companies already do). If they balk, politely ask whether they would be willing to make up the difference to the extent that the managed mutual funds underperform their respective benchmark indices.

If Plan A fails or if you hesitate to share a little common sense with your employer, try Plan B: Anonymously give your employer a copy of this book and highlight this chapter.

If your employer thinks indexing a retirement account is a far-fetched idea, tell your employer that indexing is the preferred method of investing for the very large and sophisticated public pension plans that have a fiduciary responsibility to do the right thing in providing for their employees at retirement, and you are wondering whether they have the same type of commitment.

That is, continue to focus on the goal of approximating the stock market average with the managed mutual funds you have chosen from your company plan by not switching them, trading them, or swapping them for something else—except when you rebalance your investment portfolio every year-end.

If you need help figuring out which of your plan’s funds fall into which categories (large-cap, small-cap, and international), ask your benefits coordinator or mutual fund company to help you. If you find out that your retirement plan has ten large-company funds, six small-company funds, and four international funds, it is not necessary to own all twenty funds. Choose one or two from each group and then stick with them. If your funds begin to underperform the other funds in the same group, don’t worry about it, because once you switch to another fund, you have fallen into the trap of using the dishwasher method of choosing mutual funds, which we found out in the last chapter doesn’t work.

Remember, if you invest in more than two actively managed mutual funds in each of the three common-stock groups, you are making your investment journey unnecessarily cluttered.

Diversification and making sure you come as close as you can to approximating the stock market average are what building a common-stock portfolio is all about. Unfortunately, the ease with which you are able to access your account through tools such as telephone switching privileges or access through the Internet might lead you to believe that your stock market success is based on your ability to quickly and cleverly move among top funds and hot stocks and navigate through an uncertain economy.

This switch to the get-rich mentality that is so pervasive in the investment world is absolutely disastrous for someone who is serious about building and maintaining a successful common-stock portfolio.

In addition to investing in mutual funds in a qualified retirement account, many employees who work for publicly traded companies are also given the opportunity to invest some of their retirement money in company stock. If you think you are working for a good company, then it is a good idea to own some of that company. But be careful. Too much of a good thing can turn out to be a bad thing.

There are countless instances in which great companies have experienced declines of 40 percent, 50 percent, 60 percent, or more in the price of their stock for no explainable reason, even when the stock market as a whole has gone up in value. If you feel confident in your ability to predict the inexplicable and are willing to risk a substantial amount of your retirement assets on this ability, then who am I to caution otherwise?

If you prefer a successful, diversified investment strategy instead with the money you are counting on to live on when you retire, don’t allocate more than 10 percent to 20 percent of your retirement money to your company’s common stock, and don’t forget to reallocate your company stock in the same way you reallocate your other assets at the end of each year.