My Investments
If you choose to invest in more than one fund, here’s how, using my own investments as a case study. If you haven’t already, read “How to Invest”. Updated March 25, 2017.
Should I invest in more than one fund?
If you started investing as described in “How to Invest”, and that is all you are currently comfortable with, you don’t need to do anything more. Simply continue to get used to periodically buying shares of one stock index fund, filing the related tax forms every year, and exploring around your new investment account(s).
If you are curious about investing in more than one fund, then here are guidelines for how to do so, using my own investments as an example. Note that, since you likely have a different financial situation, savings goals, and tolerance for risk than I do, you may not want to identically replicate my setup.
What funds do you invest in?
Here are my funds and the reason for each:
Vanguard Total Stock Market Index Fund: This is the basic stock index fund recommended in “How to Invest”.
Vanguard Total International Stock Market Index Fund: This is the same as the “Total Stock Market Index Fund,” except that it invests in non-US companies like Nestle, Samsung, etc. I added this because I like the idea of investing in companies worldwide. However, these two funds behave similarly – when the US stock market rises or falls, the rest of the world generally follows, and vice versa. Therefore, this fund is not necessary, or I could have stuck with just one of these two funds.
Vanguard Total International Bond Index Fund: Bonds are completely different from stocks, and are not part of the stock market at all. When you buy bonds, you are lending out your money, usually to the government. Your profits are the interest paid to you for your loan. Bonds are less “risky” than stocks, meaning that their value doesn’t rise and fall as wildly as stocks do. They grow much less than stock investments, but you’re also less likely to lose money on them.
They also are not “correlated” to stocks: when stocks do poorly, bonds don’t necessarily follow, and vice versa. Therefore, they are a good fund to add. This is called “diversification,” and it reduces risk – when one fund is not doing well, at least some of your money is in a very different fund that is not following the same behavior. (Recall from “What Is Investing?” that we buy a stock index fund because it is more diversified – and hence less risky – than buying shares of individual companies.)
The Vanguard Total Bond Market Index Fund is an index fund of US bonds. I chose the international version of this fund because I already invest in US bonds elsewhere.
Vanguard REIT Index Fund: A “REIT” (Real Estate Investment Trust) fund invests only in real estate. This is an example of a “specialty” fund, which invests in very specific industries like healthcare, gold, etc. Such funds are much more risky than stock index funds and charge higher expense ratios. I invest in this fund for fun – it is not necessary.
The general recommendation is to have one stock index fund and one bond index fund – notice that 2 of my 4 funds above were not necessary. As always, remember to check that a fund’s expense ratio is as close to zero as possible. No one knows whether a fund will make or lose money in any given year, but the expense ratio is the percentage of your money that you are guaranteed to lose every year.
How much money do you put in each fund?
If you have many years to go before you retire, almost all of your money should be in stocks – you want your money to grow as much as possible during this time, and stock market crashes shouldn’t bother you when you are not living off of your investments. A good guideline is 90% stocks and 10% bonds (with the percentage of bonds increasing when you get close to retirement).
Unnecessary and risky investments should make up no more than 10% of your investment total – I call this “play money.” For me, this is an REIT index fund; others may use their “play money” to invest in other specialty funds, gamble on stocks of individual companies, and the like.
Using these guidelines, below is my resulting asset allocation:
- 40% Stock Index Fund (US)
- 40% International Stock Index Fund
- 10% Bond Index Fund
- 10% REIT Index Fund
Rebalancing: Every time I invest money, I check to see what percentage of my investment total each fund makes up. If a fund dropped in value so that its percentage of the total is less than desired, I put more money into it. If a fund rose in value so that its percentage of the total is higher than desired, I put less or no money into it. Bringing your investments back to its asset allocation is called “rebalancing.” (In a retirement account, you can also rebalance once a year by selling shares of one fund to buy more of another fund. However, doing this in a regular investment account may affect the amount of tax you pay.)
Without an asset allocation, your instinct may be to buy more of a fund if it has gone up in value, and put less money into it when it’s not doing well. This is counterproductive – it makes no sense to buy a fund when its share price is high, and not buy shares when their price is low. Rebalancing to an asset allocation forces you to do the right thing: buy more of a fund when its price has dropped, and buy less when its price has risen.
This is why your asset allocation – and sticking to it via rebalancing – may be even more important than which funds you choose, and helps you get the most benefit out of having multiple funds.
Tax sheltering
Recall from “How to Invest” that you have to pay taxes on dividends you earn in a regular investment account. Some funds pay out dividends more frequently than others. For example, “tax-inefficient” bond and REIT funds pay out dividends more frequently than “tax-efficient” stock index funds.
To reduce my taxes, I place the tax-inefficient bond and REIT index funds in my Roth IRA, and the tax-efficient stock index funds in my regular investment account. This is called “tax sheltering.” Here is a scale of which types of funds are more tax-efficient than others, with suggestions on which to place in retirement vs. regular investment accounts.
This concludes the investing basics that any person needs to know. Happy investing, and may your financial future be secure!
Resources
“The Intelligent Asset Allocator” by William Bernstein covers the fine art of asset allocation: how to come up with one for your life situation and risk tolerance, as well as rebalancing and tax sheltering strategies. The title is a play on the classic book “The Intelligent Investor” recommended in “What Is Investing?”
Bogleheads is a Wikipedia-like resource of extremely useful investing tutorials and advice. It is named after John Bogle, the founder of Vanguard. There is also a forum in which anyone online can post and answer questions.
Supplement: Guide to understanding the information in a fund’s profile page