Chapter 10

Perfecting a Fund Portfolio

In This Chapter

Creating the best mix of funds for your situation

Understanding how taxes factor into selecting funds

Recognizing wise and unwise fund investing strategies

Executing your plan

Although portfolio usually describes a collection of funds, it doesn’t have to. For certain goals, one or two funds may be all that you need (for example, a short-term bond fund and a money market fund for a home down payment). Even for a long-term goal, such as retirement, you may select just one fund; some mutual fund companies offer funds of funds, which, as the name suggests, are mutual funds comprised of other mutual funds. (See Chapter 13 for details on such funds.) And although a portfolio is sometimes held inside one account, it doesn’t have to be. The funds that make up your retirement portfolio, for example, could be in numerous accounts from different investment companies.

This chapter shows you how to draw up a blueprint for your investing goals that includes all the key considerations, including asset allocation (how you divvy up your portfolio among different investments), tax implications (especially for portfolios held outside of tax-sheltered retirement accounts), and some mutual fund investing strategies. I then help you execute your plan.

Asset Allocation: An Investment Recipe

Asset allocation simply describes the proportion of different investment types (stocks, bonds, international investments, and so on) that make up your mutual fund portfolio. So if someone asks, “What’s your asset allocation?” a typical response may be, “I have 60 percent in stocks, a third of which is in foreign stocks, and 40 percent in bonds.”

You may hear a mutual fund nerd spout off about his allocation using more detailed terminology including large-cap and small-cap stocks, or between growth funds and value funds. Don’t worry about these terms for now. (Check out Chapter 13 for more information about these terms.)

Allocating to reduce your risks

You wouldn’t have to worry about asset allocation if it weren’t for a simple investment truth: The greater an investment’s potential return, generally the greater the chance and magnitude of a short-term loss. If there were no chance of loss, you could throw asset allocation out the window. No matter what your savings goal, you could put all your money into stocks. After all, in comparison to bonds and money market investments, stocks should give you the biggest long-term returns (see Chapter 1 for more details). If you had no chance of loss when investing in stocks, every dollar you saved would go to creating wealth in stocks. Your net worth would balloon.

In the real world, stocks are a volatile investment. Although providing the highest long-term gains, stocks also carry the greatest risk of short-term loss (compared with putting your money in bonds or money market accounts).

Asset allocation, then, is all about striking the right balance between your desire for higher returns and your ability to withstand a short-term loss. All things being equal, all people prefer higher returns. And although everyone has a different personality and temperament about accepting risk, your realistic ability to withstand a loss depends primarily on your time horizon.

Looking toward your time horizon

The time horizon of a financial goal is the length of time between now and the time when you expect to need the money to accomplish that goal. If you’re currently 30 years old and want to retire by age 60, then the time horizon of your retirement investments is 30+ years from now (even though you’ll begin to use some of your retirement money at age 60, some of it won’t be spent until later in your retirement). If you’re saving to buy a home by the time you’re 35 years old, then the time horizon of that goal is five years from now.

The longer your time horizon, the more able you are to withstand the risk of a short-term loss. For example, if you have a 30-year time horizon for retirement investments, then a short-term loss isn’t a big deal — your investments have plenty of time to recover. Thus, you probably want more of your retirement dollars in growth investments, such as stocks.

Short-term goals

Asset allocation for goals with short time horizons is quite simple:

Less than two years: If you have less than two years, you’re generally best off sticking to money market funds. Stocks and bonds are volatile, and although you have the potential for earning higher returns in stocks and bonds, a money market fund offers the combination of terrific safety and some returns. See Chapter 11 for more on money market funds.

Between three and seven years: If your time horizon is between three and seven years, then consider using shorter-term bond funds. (If you have between two and three years, you can use both money market and short-term bond funds.) When you’re able to keep your money in an investment for several years, then the extra potential returns from low-risk bonds begin to outweigh the risk of short-term loss from possible bond market fluctuations. See Chapter 12 for more on bond funds.

Seven or more years: If your time horizon is seven years or more, I think that you have a long enough time horizon to start investing in stocks as well as longer-term bonds.

Some market pundits and those involved with money management refer to extended periods such as the 2000s as the lost decade. These people will point to a market index such as the Dow Jones Industrial Average and exclaim that from the end of 1999 through the end of 2009, that index of 30 large U.S. company stocks essentially treaded water and ended the decade at about the same level it began the decade. This statement is highly misleading and inaccurate. During that decade, numerous U.S. and foreign stock indexes posted healthy returns of between 5 and 10 percent annually. Bond investors did well over that period as well. And, you should also remember that these folks are overlooking the dividend payments stock investors earn and that are not reflected in the quoted level of a given market index. While some commentators are simply ignorant of these facts, others, especially those managing money, selling newsletters, and advocating market timing, have an agenda to convince you that buying and holding don’t work and that you need their services to time the market. Please see the section “Timing versus buy-and-hold investing,” later in this chapter, as well as Chapter 20, which discusses market forecasters.

Retirement and other long-term goals

Long-term goals, such as retirement and college tuition, require more complex asset allocation decisions than those demanded by short-term goals. If you plan to retire in your 60s, your retirement portfolio needs to fund your living expenses for 20 or more years. That’s a tall order. Unless you have vast wealth in comparison to your spending desires, the money you’ve earmarked for retirement needs to work hard for you. That’s why you should heavily weight a portfolio that you’re investing for your future retirement, particularly during your earlier working years, toward investments with appreciation potential like stocks.

Your current age and the number of years until you retire should be the biggest factors in your retirement asset allocation decision. The younger you are and the more years you have before retirement, the more comfortable you should be with growth-oriented investments, such as stock funds.

As you approach retirement age, however, you should gradually scale back the risk and volatility of your portfolio. That’s why, as you get older, bonds should become an increasingly bigger piece of your portfolio pie. Although their returns are generally lower, bonds are less likely to suffer a sharp downswing in value that could derail your retirement plans.

Table 10-1 in the next section lists some guidelines for allocating money you’ve earmarked for long-term purposes, such as retirement. All you need to figure out is how old you are (I told you investing was easier than you thought!) and the level of risk you’re comfortable with.

Factoring in your investment personality

In Table 10-1, I add a new variable to the asset allocation decision: your investment personality, or tolerance for risk. Even if you and another investor are the same age, and you both have the same time horizon for your investments, you could very well have different tolerances or desires to accept and deal with risk. Some people are more apt to lose sleep over their investments, just as some people are scared by roller coasters, whereas other people get a thrill from them.

Table 10-1 Asset Allocation Guidelines for the Long Haul
Your Investment Attitude	Bond Allocation (%)	Stock Allocation (%)
Play it safe	Age	100 – age
Middle of the road	Age – 10	110 – age
Aggressive	Age – 20	120 – age

Be honest with yourself and invest accordingly. If you’re able to accept who you are instead of fighting it, you’ll be a happier and more successful investor. Here’s my advice for how to categorize yourself:

Play it safe: Indicators of this investment personality include little or no experience or success investing in stocks or other growth investments, fear of the financial markets, and risk-averse behavior in other aspects of life. You may desire to be conservative with your investments if you have enough saved to afford a lower rate of return on your investments.

Middle of the road: Indicators of this investment personality include some experience and success investing in stocks or other growth investments, and some comfort with risk-taking behavior in other aspects of one’s life.

Aggressive: Indicators of this investment personality include past experience and success investing in stocks or other growth investments — and a healthy desire and comfort with sensible risk-taking behavior in other aspects of one’s life. You may also want to be more aggressive if you’re behind in saving for retirement and you want your money to work as hard as possible for you.

What does it all mean, you ask? Consider this example. According to Table 10-1, if you’re 35 years old and don’t like a lot of risk but recognize the value of striving for some growth to make your money work harder (a middle-of-the-road type), you should put 25 percent (35 – 10) into bonds and 75 percent (110 – 35) into stocks.

Divvying up your stocks between home and abroad

Your next major asset allocation decision is to divvy up your stock investment money between U.S. and international stock funds. This step is an important one for keeping your portfolio properly diversified. Although some consider international markets risky, putting all your stock market money into just one country is even riskier, even if the country is relatively large and familiar, such as the United States.

When the U.S. market slumps, some markets do better. Moreover, developing countries have the potential for greater economic growth and stock market returns than the U.S. market. Here’s the portion of your stock allocation that I recommend investing overseas, guided by your investment attitude:

Play it safe: 20 percent

Middle of the road: 33 percent

Aggressive: 40 to 50 percent

So if you’re a 35-year-old, middle-of-the-road type who’s investing 75 percent of your portfolio in stocks, you’d then put 33 percent of that stock money into international stock funds. Multiplying 33 percent by 75 percent works out to be about 25 percent of the entire portfolio. So you’d put 25 percent in bonds, 50 percent in U.S. stocks, and 25 percent in international stocks.

Gradual change is better than abrupt change. If you’ve had little or no experience or success investing in stocks, you’re better to start with the play-it-safe allocation and then work your way to riskier allocations as you develop more comfort and knowledge.

College savings goals

Be careful when investing money for your child’s college education. Doing so the wrong way can harm your child’s chances of getting needed financial aid and increase your tax burden (see Chapter 3 for more information).

The strategy for allocating money in a college savings portfolio can be similar to that used for retirement money. Assuming that your child is young, the goal is relatively long term, so the portfolio should emphasize growth investments, such as stocks. However, as the time horizon decreases, bonds should play a bigger role. The big difference, of course, between investing for your retirement and investing for your child’s college costs is that the time horizon for college depends not on your age, but on the age of the child for whom you’re investing.

Here’s my rule for investing college money for your kids. To figure how much money you should put in bonds, take the following numbers:

Play it safe: 60 + child’s age

Middle of the road: 45 + child’s age

Aggressive: 30 + child’s age

The rest of your college investment should go into stocks (with at least a third in stocks overseas). Use this rule to adjust the mix as your child gets older. For example, suppose that you have a 5-year-old, and you want to follow a middle-of-the-road approach when investing her college money. In this case, you could invest approximately 50 percent (45 + 5) in bonds, with the remaining 50 percent in stocks, one-third of which you’d invest overseas.

Taxes: It’s What You Keep That Matters

Like asset allocation, tax implications are a fundamental consideration in portfolio construction. When you’re constructing a mutual fund portfolio outside of a tax-sheltered retirement account, Uncle Sam gets to grab a share of your returns. Part of what makes up a mutual fund’s returns are dividend distributions and capital gains, which are subject to taxation.

For this reason, when you’re investing outside of tax-sheltered retirement accounts, you must distinguish between pre-tax and post-tax returns. Think of it as the business world difference between revenue and profit. Revenue is what a business collects from selling products and services; profit is what a business gets to keep after paying all of its expenses, and in the end, that’s what really matters to a business. Likewise, your after-tax return, not your pre-tax return, should matter most to you when you invest your money.

Unfortunately, all too many investors (and often their advisers) ignore the tax consequences and invest in ways that increase their tax burdens and lower their effective returns. For example, when comparing two similar mutual funds, most people prefer a fund that earns returns of 13 percent per year on average to a fund that earns 12 percent. But what if the 13 percent per year fund causes you to pay a lot more in taxes? What if, after factoring in taxes, the 13 percent per year fund nets you just 9 percent, while the 12 percent per year fund nets you an effective 10 percent return?

In the following sections, I help you plan how funds fit in your portfolio, given your current tax bracket, and how to ensure that the tax bite is as painless as possible. Check out Chapter 18 for all the ins and outs of accounting for your funds when filing your tax return.

Fitting funds to your tax bracket

Fortunately, you can pick your funds to minimize the federal and state governments’ shares of your returns. Some funds, for example, are managed to minimize highly taxed distributions, and certain government bond funds focus on investments that generate tax-free income.

Understanding ordinary (marginal) income tax rates

To choose the right funds for your investment purposes, you must know your marginal tax rate, which is the rate you pay on the last dollar you earn. For example, if you earned $50,000 last year, the marginal rate is the rate you paid on the dollar that brought you from $49,999 to $50,000. The government charges you different tax rates for different parts of your annual income.

You pay less tax on your first dollars of earnings and more tax on your last dollars of earnings. For example, if you’re single and your taxable income totaled $50,000 during 2010, you paid federal tax at the rate of 10 percent on the first $8,375 of taxable income, 15 percent on the income from $8,375 to $34,000, and 25 percent on income above $34,000 (see Table 10-2). The rate you pay on those last dollars of income (25 percent) is your marginal rate.

Your marginal tax rate allows you to quickly calculate how much tax you owe on additional salary and certain types of nonsalary income, such as

Interest from taxable bonds

Interest from taxable money market funds

Short-term capital gains (that is, gains from investments sold after being held for one year or less)

Suppose that on top of your $50,000 salary you have some bond funds that pay taxable interest in a nonretirement account that distributed $1,000 of dividends. Because you know your marginal tax rate — 25 percent — you know that Uncle Sam gets $250 of that $1,000 distribution ($1,000 × 25 percent). Note that states generally also levy income taxes. Table 10-2 shows federal tax rates for singles and for married couples filing jointly.

Table 10-2 2010 Federal Income Tax Brackets and Rates
Singles’ Taxable Income	Married-Filing-Jointly Taxable Income	Federal Tax Rate
Less than $8,375	Less than $16,750	10%
$8,375 to $34,000	$16,750 to $68,000	15%
$34,000 to $82,400	$68,000 to $137,300	25%
$82,400 to $171,850	$137,300 to $209,250	28%
$171,850 to $373,650	$209,250 to $373,650	33%
More than $373,650	More than $373,650	35%

Lower tax rates on stock dividends and long-term capital gains

In 2003, a major federal tax bill significantly lowered the tax rate applied to

Dividends paid by corporations (domestic or foreign) on their stock

Long-term capital gains (from profits on appreciated investments sold after being held for more than one year)

For those in the four highest federal income tax brackets listed in Table 10-2 (25, 28, 33, and 35 percent), the tax rate on stock dividends and long-term capital gains is just 15 percent. And, get this, stock dividends and long-term capital gains are tax-free for taxpayers in the 10 and 15 percent federal income tax brackets!

Although the income paid on bond funds and money market funds is called a dividend, such income doesn’t qualify for the new, lower federal income rates on stock dividends. Dividend income that you receive from mutual funds holding stocks qualifies for the lower dividend tax rate.

Minimizing your taxes on funds

Now that you’re equipped with knowledge about your tax bracket and tax rates on various fund distributions (if you don’t have a clue and skipped the preceding section, you may want to visit it before continuing here), the following sections enable you to understand how to select tax-friendly mutual funds when investing outside of retirement accounts.

Use tax-free money market and bond funds

Certain kinds of money market and bond funds invest only in bonds issued by governments, and depending on the type of government entity they invest in, their dividends may not be subject to state and/or federal tax.

Such funds are typically identified by the words Treasury or municipal in their fund titles:

A Treasury fund buys federal-government-issued Treasury bonds (also called Treasuries), and its dividends — although federally taxable — are free of state taxes.

The dividends of a municipal bond fund, which invests in local and state government bonds, are free of federal tax, and if the fund’s investments are limited to one state and you live in that state, the dividends are free of state taxes as well.

Because Treasuries and municipal bonds aren’t subject to complete taxation, the governments issuing these bonds can pay a lower rate of interest than, say, comparable corporate bonds (the dividends on which are fully taxable to bondholders). Therefore, before taxes are taken into account, tax-free bond and money market funds yield less than their taxable equivalents.

However, after taxes are taken into account, you may find that with tax-free money market or bond funds, you come out ahead of comparable taxable funds if your tax bracket is high enough. Because of the difference in taxes, the earnings from tax-free investments can end up being greater than what you’re left with from comparable taxable investments. If you’re in the 28 percent federal bracket or higher (see Table 10-2), see Chapters 11 and 12 for details on tax-free money market and bond funds.

Don’t buy tax-free funds inside retirement accounts. Your returns inside a retirement account are already sheltered from taxation. Ignore the taxability of funds and go for the highest yields.

Invest in tax-friendly stock mutual funds

Unfortunately, stock mutual funds don’t have a tax-free version like bond and money market funds do. Unless they’re held inside a retirement account, stock fund distributions are taxable. However, as discussed in the previous sections, not all stock distributions and returns are treated equally from an income tax standpoint. With stock funds, more than any other type of fund, investors often focus exclusively on the pre-tax historical return, ignoring the tax implications of their fund picks.

You can invest in stock funds that are tax friendly — in other words, funds whose investing style keeps highly-taxed distributions to a minimum. Here’s how stock funds can minimize taxable distributions:

Buy-and-hold investing: Dividends and capital gains are two types of stock fund distributions. Capital gains distributions are generated when a fund manager sells a stock for a profit; that profit must then be given out to the shareholders annually. Some fund managers engage in frequent trading, which can cause their funds to produce more distributions. But other fund managers are buy-and-hold investors. These managers tend to produce fewer capital gains distributions than their peers who trade frequently.

Index mutual funds and exchange-traded funds tend to produce fewer capital gains distributions because they hold their securities longer. (For more on indexing, see “Fund Investing Strategies” later in this chapter, as well as Chapter 13 for more details on stock index funds.)

Long-term capital gains: Although no capital gains’ distributions are best for minimizing taxes, a good manager ultimately sells some stocks at a profit when he sees better opportunities elsewhere. When a fund manager does sell stocks at a profit, you pay a far lower tax rate when these realized gains are long term — from stocks held more than one year. (See the section “Lower tax rates on stock dividends and long-term capital gains,” earlier in this chapter.)

Offsetting gains with losses: If a fund manager sells some stock for a gain of $10,000 but sells other stock for a loss of $10,000, the capital gains net out to zero. Some funds, managed specifically to minimize distributions, employ this offsetting technique to lower their capital gains. I identify the best of these tax-managed stock funds in Chapter 13.

Watch the calendar

When purchasing stock mutual funds outside of tax-sheltered retirement accounts, consider the time of year at which you purchase shares in funds. December is the most common month in which mutual funds make capital gains distributions. Most funds also make a dividend distribution around that time as well. (Dividends are also sometimes distributed at other times of the year, especially on bond funds.)

Don’t invest in a fund just before it makes a large distribution. You’re not reaping any rewards from the capital gains distribution because, right after such a distribution, the fund’s share price decreases to reflect the size of the payout. You are, however, effectively making yourself liable for taxes on gains you didn’t share in.

When making purchases late in the year, find out whether and when the fund may make a significant capital gains and dividend distribution. Fund companies can usually tell you, in advance of the actual capital gains and dividend distribution, approximately how much they expect the distribution to be.

Fund Investing Strategies

In this section, I discuss some of the different investing strategies and philosophies that you can use to direct a mutual fund portfolio, and I also explain which ones are best for you and which ones to avoid. Having an overarching strategy is vital for many reasons. Without a clear plan and approach, you’ll have less success, more anxiety, and more temptation to fall prey to sales pitches and unsound approaches.

Timing versus buy-and-hold investing

Over the past two centuries, stocks have produced an average return of about 9 to 10 percent per year. Some individual years are better, with stocks returning up to 20 or even 30 percent or more; other years are worse, with stocks losing 20 percent or more in value. But when taken over a period of decades, the up years and the down years historically net out to returns of about 9 to 10 percent per year.

Despite the long-term healthy returns stocks generally produce, it’s disconcerting to some people to invest their money into something that can decline. Many newsletters, advisers, and the like claim to predict the future movement of the financial markets. On the basis of such predictions, these folks advocate timing the purchase and sale of securities, such as stocks, to maximize returns and minimize risks.

Although market timing sounds good in theory, a wealth of studies and evidence shows that market timing simply doesn’t work in practice. (In Chapter 20, I discuss the historically poor track record of investment newsletters that attempt market timing.) In fact, those who try to time the markets inevitably do worse than those who simply buy and hold, because they too often miss the right times to buy and sell.

Market timing is based on that age-old investment mantra, “Buy low, sell high.” It sounds so simple and logical; perhaps that’s what makes it such an attractive concept. One fundamental problem, however, destroys the logic: Recognizing a low or a high comes only with hindsight; market movements, especially in the short term, are unpredictable. Telling someone to buy low and sell high is similar to telling someone that it’s okay to drive his car if he expects not to have an accident and that he should stay out of his car if he expects to have an accident!

If buying and holding had an investment mantra, it would be “Buy now, sell much later.” Instead of betting on short-term market movements, buy-and-hold investors do their homework and select solid funds and rely on long-term trends and aren’t so concerned with when to get in and out of the market as much as how long they’re actually in there. Buy-and-hold investors know that if they hang in there through the inevitable tough times, the good years outnumber the bad, and they come out ahead.

Don’t jump in and out of funds. After you’ve bought into a decent fund, you have few good reasons to move out of it (see Chapter 17). Not only does buy-and-hold investing offer better returns, but also it’s less work and hassle.

Active versus index fund managers

Unlike other mutual funds, in which the portfolio manager and a team of analysts scour the market for the best securities, an index fund manager passively invests to match the performance of an index. Index funds are funds that can be (and, for the most part, are) managed by a computer, with intelligent human oversight. An index fund manager invests the fund’s assets so as to replicate an underlying index, such as Standard & Poor’s 500 index — 500 large-company U.S. stocks. An S&P 500 index fund generally buys and holds the same 500 stocks, and in the same approximate amounts, that comprise the S&P 500 Index.

Index funds are underrated — they don’t get the credit they deserve. Index funds are a little bit like Jaime Escalante, that Garfield High School math teacher of poor children in the ghettos of Los Angeles (see the terrific movie, Stand and Deliver, about him). In a school where kids often dropped out and were lucky to learn some algebra, Escalante got his kids to master calculus. In fact, he got entire classes to work hard and pass the college advanced placement exam for calculus. (The College Board that administers the AP test couldn’t believe that so many kids from this school could pass this exam, so the kids were investigated for cheating — that’s how Escalante’s story was discovered, and he finally got credit for all the great work that he did.)

Low-cost index funds work hard by keeping expenses low, staying invested, and holding on to a relatively fixed list of stocks. So, like Escalante’s kids, index funds are virtually guaranteed to be at the top of their class. Over long periods (ten years or more), index funds outperform about three-quarters of their actively-managed peers investing in the same types of securities! Most actively managed funds can’t overcome the handicap of high operating expenses that pulls down their funds’ rates of return. Because significant ongoing research doesn’t need to be conducted to identify companies to invest in, index funds can be run with far lower operating expenses. (Please also see Chapter 5 for a discussion of the exchange-traded funds, which are index funds you can buy and sell on a stock exchange.)

The average U.S. stock fund has an operating expense ratio of 1.5 percent per year. (Some funds charge expenses as high as 2 percent or more per year.) That being the case, a U.S. stock index fund with an expense ratio of just 0.2 percent per year has an average advantage of 1.3 percent per year. A 1.3 percent difference may not seem like much, but in fact, the difference is significant. Because stocks tend to return about 10 percent per year, you’re throwing away about 13 percent of your expected stock fund returns when you buy a non-index fund. If you factor in the taxes that you pay on your fund profits, these higher expenses gobble even more of your after-tax profits.

Another often overlooked drawback to actively managed stock funds: Your fund manager can make costly mistakes, such as not being invested when the market goes up, being too aggressive when the market plummets, or just being in the wrong stocks. An actively managed fund can easily underperform the overall market index that it’s competing against. An index fund, by definition, can’t.

Table 10-3 lists the worst-performing U.S. stock funds over the past decade. Note how much worse these bowser funds performed versus the broad U.S. stock market index. The past decade was one of the worst for U.S. stocks in history for sure, but you can clearly see that the worst funds underperformed relevant market indexes by about 12 to 30 percent per year over this decade long time span!

Table 10-3 Worst Performing U.S. Stock Funds versus Market Indexes
Fund	Annualized Total Return
Embarcadero Absolute Return	–26.4% per year
Embarcadero Market Neutral	–19.2% per year
First American Mid Cap Select A	–15.5% per year
BlackRock Focus Growth A	–12.8% per year
Apex Mid Cap Growth	–11.9% per year
Stock Market Indexes	Annualized Total Return
Russell 2000	+3.8% per year
DJ Wilshire 5000 Index	0.0% per year

Source: Morningstar, Inc.

When you invest in broadly diversified index funds, you never see your funds in the list of the top-performing funds — but then you never see your funds in the list of the worst-performing funds, either. Don’t overestimate your ability to pick in advance the few elite money managers who manage to beat the market averages by a few percentage points per year in the long run. And then don’t overestimate the pros’ ability to consistently pick the right stocks.

Index funds make sense for a portion of your investments, especially when investing in bonds and larger more-conservative stocks, where it’s difficult for portfolio managers to beat the market. Index funds also make sense for investors who are concerned that fund managers may make big mistakes and greatly underperform the market.

As for how much you should use index versus actively managed funds, it’s really a matter of personal taste. If you’re happy knowing that you can get the market rate of return and knowing that you can’t underperform the market, you can index your entire portfolio. On the other hand, if you enjoy the game of trying to pick the better managers and want the potential to earn better than the market level of returns, don’t use index funds at all. A happy medium is to do some of both.

Putting Your Plans into Action

Constructing a mutual fund portfolio is a bit like constructing a house: There’s a world of difference between designing a plan and executing it. If you’re the architect, your world is all clean lines on white paper. But if you’re the general contractor responsible for executing the plan, your circumstances are generally messier; you may face such challenges as inclement weather, unsuitable soil, and undependable construction workers.

Like the contractor, you’re bound to meet challenges in the execution of the plan — in your case, constructing a mutual fund portfolio instead of a house. Some of these challenges come from the funds themselves; your personal circumstances are the source of others. With patience, persistence, and a healthy helping of my advice, all are surmountable. Investing in funds is much, much easier than building a house — which is why you can do it yourself if you so desire.

Determining how many funds and families to use

Suppose that you’ve used the discussion earlier in this chapter to nail down an asset allocation for your retirement portfolio: 25 percent in bonds, 50 percent in domestic stocks, and 25 percent in international stocks. That’s all quite specific except for the fact that these percentages tell you nothing about how many funds and how many fund families you should use to meet these percentages. (I introduce the concept of fund families in Chapter 2).

You could do all your investing through one family of funds, given the sheer number and quality of funds that the larger and better fund companies. Centralizing your investments in one family saves on administrative hassles by cutting down on the number of applications to complete, envelopes to open, statements to file, tax statements to deal with, and so on. Plus, you’re more likely to find your way around better at a company that you spend more of your time interacting with. Consider a good argument against investing through one family of funds, though: Even the best mutual fund companies don’t offer the best of every type of fund. By not spreading out your funds over different fund families to take advantage of their particular strengths, you may be sacrificing a little bit of return.

Discount brokerage services offer some of the best of both approaches. You get one-stop shopping and one statement for all your holdings, but you also have access to funds from many families. The downside: You pay small transaction fees to purchase many of the better funds through discounters. (I discuss discount brokerage services in detail in Chapter 9.)

You won’t find one right answer to how many fund families to work with and whether to use a discount brokerage account. Choose the approach that works best for your needs. I use a combination of these approaches by maintaining accounts through a large mutual fund company while also using discount brokerage services to buy funds from some of the smaller fund families that are more of a hassle to work with. This strategy allows me to maximize centralization while minimizing transaction fees.

As for the number of individual funds to hold in your portfolio, again, there’s no one correct answer. The typical mutual fund is quite diversified to begin with, so you needn’t invest in too many. In fact, because some funds invest across different types of investments (known as hybrid funds) or even across other funds (known as funds of funds), you may be able to achieve your desired asset allocation by investing in just one fund.

At a minimum, I recommend that you own enough funds so that you’re able to diversify not only across the general investment types (stocks, bonds) that you’ve targeted but also across different types of securities within those larger categories — bonds of various maturity lengths, stocks of various-size companies. (I explain these concepts in Chapters 12 and 13.)

As your savings allow, I generally recommend that you invest at least $3,000 to $5,000 per fund. If you’re investing outside of a retirement account, most of the better mutual funds require an initial investment of this magnitude anyway. Inside a retirement account, you may invest less — typically only $500 or $1,000 per fund — to start. However, because most retirement accounts annually ding you about $10 per fund as an account maintenance fee, you should aim to invest the higher amounts so you don’t have your small investment devoured by high relative fees. (A $10-per-year fee diminishes a $500 investment by 2 percent each year.) Some fund companies waive this fee if you keep more than a certain amount — $5,000, for example — in their funds.

As you have larger sums to invest, it makes sense to use more funds. Suppose that you have $300,000 and want to divide it equally among bonds, U.S. stocks, and international stocks. You could put $100,000 into each of three funds: one bond fund, one U.S. stock fund, and one international stock fund. But with that much money to invest, why not use at least two of each of the different types of funds? That way, if the one international stock fund you’ve chosen does poorly, all of your money earmarked for overseas investing isn’t doing poorly in that fund. There’s no reason that you can’t use even three different funds within each category. The more money you have, the more sense diversifying across two or three funds per category makes.

And one more point: Don’t invest in more funds than you have time to track. If you can’t find the time to read your funds’ semiannual and annual reports, that’s a sign that you have too many funds. Extra diversification won’t make up for a lack of monitoring.

Matching fund allocation to your asset allocation

One thing that can trip up your asset allocation plans is the fact that mutual funds have their own asset allocations. For example, a hybrid fund may invest 60 percent in stocks and 40 percent in bonds. Perhaps you, on the other hand, want to invest 75 percent in stocks and 25 percent in bonds. How the heck do you fit that kind of fund into your portfolio?

One option is to shun hybrid funds. Take Thoreau’s advice to simplify your (investing) life: Avoid funds that invest in different investment types. Buy purebreds — stock funds that are 100 percent (or close to 100 percent) invested in stocks, bond funds that invest only in bonds, and international stock funds that are entirely invested overseas. That way, your asset allocation calculations stay simple.

Take the desired mix of the hypothetical 35-year-old from earlier in this chapter: 25 percent in bonds, 50 percent in U.S. stocks, and 25 percent in international stocks. If she has $10,000 to invest and sticks to purebred funds, figuring out how much money to put into each kind of fund is a simple matter of multiplying the desired allocation percentage by the $10,000 total to invest. In this case, she should put $2,500 in a pure bond fund (25 percent × $10,000), $5,000 in a U.S. stock fund, and $2,500 in an international stock fund.

If that seems a little too easy, you’re right. Even if they label themselves as purebreds, plenty of mutual funds are given leeway in their charters to dabble in other investment types. Read the annual report of some so-called U.S. stocks funds and you may find that up to 20 percent of their assets are invested in bonds or international stocks.

Some hybrid funds are excellent funds, and eliminating them simply to avoid a math problem seems a bit silly. Although I encourage you to focus on purebred funds, fitting a hybrid fund, or a hybrid disguised as a purebred, into your portfolio occasionally makes sense.

Take the example of a 35-year-old investor — one who wants a portfolio of 25 percent bonds, 50 percent U.S. stocks, and 25 percent international stocks. Suppose that she’s picked out three funds she wants to buy: a U.S. stock fund (100 percent stocks), an international stock fund (100 percent international stocks), and a hybrid fund (60 percent U.S. stocks, 40 percent bonds). Because the hybrid fund is the only one with bonds, the investor needs to figure out how much to put into the hybrid fund so that she ends up with about 25 percent (overall) in bonds. Because 40 percent of the hybrid fund is invested in bonds, the arithmetic looks like this:

0.4 (40 percent) × Amount to be invested in fund = 0.25

Amount to be invested in fund = 0.25 ÷ 0.4

Amount to be invested in fund = 0.625 (or 62.5 percent)

I like nice, round numbers, so I rounded 62.5 off to 60. Here’s how much money she should put into each fund to get her desired investment mix:

60 percent hybrid fund (60 percent in U.S. stocks, 40 percent in bonds)

15 percent U.S. stock fund (100 percent in stocks)

25 percent international stock fund (100 percent in international stocks)

Allocating when you don’t have much to allocate

If you’re just starting out, you may have little money to allocate. Here you’ve spent all this time exploring how to design a terrific portfolio, and then, thanks to minimum initial investment requirements, you may realize that you only have enough money to buy one of the five funds you’ve selected!

Fear not. This problem has several answers:

Buy a hybrid fund or a fund of funds (see Chapter 13) whose asset allocation is similar to your desired mix. Don’t sweat the fact that you can’t find a fund with the exact mix you want. For now, getting close is good enough. When you’re able to afford it, you can, if you so desire, move out of the hybrid fund and into the funds you originally chose.

Buy your desired funds — one at a time — as you’re able to afford them. I call this little trick diversifying over time, and it’s perfectly legit.

One twist on this strategy that tests and perhaps improves your mutual fund investing habits is to start by investing in the type of fund (bond or international stock, for example) that’s currently doing the most poorly — that is, buy when shares are on sale. Then the next year, add the fund type that’s doing the most poorly at that time. (Make sure to buy the better funds within the type that’s doing poorly!)

For more ideas, see Chapter 15 for sample portfolios for beginning investors.

Investing large amounts: To lump or to average?

Most people invest money as they save it. If you’re saving through a company retirement plan, such as a 401(k), this option is ideal: It happens automatically, and you’re buying at different points in time, so even the world’s unluckiest person gets to buy some funds at or near market bottoms.

But what if you have what to you seems like a whole lot of money that’s lollygagging around in a savings or money market fund? Maybe it’s just piled up because you’re thrifty, or maybe you recently inherited money or received a windfall from work. You’re discovering more about how to invest this money, but after you decide what types of investments you’d like to purchase, you may be terrified at the thought of actually buying them.

Some people in this situation feel a sense of loss, failure, or even guilt for not making better use of the money than just letting it sit in a savings or money market account. Always remember one important thing: At least you’re earning a positive return in the bank or money fund, and it beats the heck out of rushing into an investment that you don’t understand and in which you may lose 20 percent or more. Of course, you have every reason to find the best parking spot that you can for your money. (See Chapter 11 for recommendations of the best money market funds.)

So how do you invest your lump? One approach is to dollar-cost average it into the investments you’ve chosen. This means that you invest your money in equal chunks regularly, such as once a month or per quarter. For example, if you have $50,000 to invest and you want to invest it once per quarter over one year, you’d invest $12,500 per quarter until it’s all invested. Meanwhile, the money that’s awaiting future investment happily continues accumulating interest in a good money market fund. Take a look at the pros and cons of this method of investing a large sum:

Thumbs up: The attraction of dollar-cost averaging is that it allows you to ease into riskier investments instead of jumping in all at once. The benefit may be that, if the price of the investment drops after some of your initial purchases, you can buy some later at a lower price. If you invest all your money at once and then the financial markets get walloped, it’s human to think, “Why didn’t I wait?”

History has proven that dollar-cost averaging is a great risk-reducing investment strategy. If you’d used dollar-cost averaging during the worst decade for stock investors in the last century (1928 to 1938), you still would’ve averaged 7 percent per year in returns despite the Great Depression and a sagging stock market.

Thumbs down: The flip side of dollar-cost averaging is that if your investments do what they’re supposed to and increase in value, you may wish that you’d invested your money faster. Another possible drawback of dollar-cost averaging is that you may get cold feet continuing to put money in an investment that’s dropping in value. Some folks who are attracted to dollar-cost averaging are afraid to continue boarding what appears to be a sinking ship.

Dollar-cost averaging also can cause headaches with your taxes when it’s time to sell investments held outside retirement accounts. If you buy an investment at many different times and prices, the accounting is muddied as you sell portions of the investment. Also, remember to try not to purchase funds, particularly stock funds that have had a good year, late in the year because most of these funds distribute capital gains in December.

In my opinion, dollar-cost averaging is most valuable when the money you want to invest represents a large portion of your total assets and you can stick to a schedule. Making it automatic is best so that you’re less likely to chicken out and discontinue investing if your initial investment purchases have declined in value from when you bought them.

Most mutual fund companies offer automatic exchange services. Pick a time period that makes sense. I like to do dollar-cost averaging once per quarter early in the quarter (the first of January, April, July, and October). If you feel comfortable investing and want to get on with the program, averaging your money over one year is fine, but it’s riskier. If you have big bucks to invest and you’re cautious, you may prefer to average the money over two to five years. (In this case, you can use some CDs or Treasury bills as holding places in order to get a better return than on the money market fund.)

Sorting through your existing investments

A final question that people who want to start a comprehensive mutual fund investment program, but who also have existing portfolios, frequently ask me is what to do with their existing investments. Here are my thoughts:

Keep the good nonfund investments. Although I’m a fan of mutual funds, there’s no compelling reason for you to invest all your money in funds. If you enjoy investing in real estate or securities of your own choosing, go right ahead. You may have inherited other assets that have done well over the long term, and you shouldn’t rush into selling them, especially if prodded to do so by a self-serving investment advisor or broker. Take your time and evaluate what you have. You can account for these other investments when you tally up your asset allocation. As for evaluating the mutual funds you may already own, see Chapter 17.

Get rid of high-fee, poorly performing investments. As you understand more about the best mutual fund investments, you may come to realize by comparison how lousy some of your existing investments are. I won’t stand in your way of dumping them!

Pay attention to tax consequences. When you’re considering selling a nonretirement account investment, especially one that has appreciated considerably since its original purchase, be mindful of taxes. Assets held for more than 12 months are eligible for the more favorable capital gains tax rates (see Chapter 10).