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What Does an Investment Portfolio Need?

I recently encountered a conversation about the characteristics of a good portfolio. The person speaking (whom I didn’t know) had a long list, but it got me thinking about what I would include on such a list.

I came up with only three things. (That is, only three characteristics that make a portfolio strictly better than a portfolio that does not have those characteristics.)

  1. Diversification,
  2. Low costs (including tax costs, if applicable), and
  3. An appropriate overall level of risk.

With regard to diversification, the most critical thing is diversification among individual holdings (unless we’re talking about FDIC-insured CDs or Treasury bonds, for which diversification isn’t needed). Point being: Don’t set yourself up for financial catastrophe if a single company goes out of business. Also helpful, but less important, is diversification among asset classes — have some stocks and some fixed-income.

With regard to costs, the lower you can get the better. But it’s important to think in dollars rather than proportions. For instance, the difference between an expense ratio of 0.8% and an expense ratio of 0.2% is much greater than the difference between 0.2% and 0.05%, even though in each case the less expensive option is 1/4 as costly as the more expensive option. On a number of occasions I’ve heard from people considering changing fund companies in order to shave just a few hundredths of a percent off their average expense ratio. It would be rare for such a change to be worth the hassle for anything other than a very large portfolio.

When it comes to choosing an appropriate level of risk, it’s important to know that this is a very rough thing. Your risk tolerance isn’t something that can be measured precisely. In addition, your risk tolerance will change over time. (And the riskiness of different combinations of investments changes over time too!) Finding something that feels “approximately right” for you is as good as you’re ever going to get here.

The reason I’m such a big fan of index funds (and/or ETFs) is that, in most cases, it’s easier to achieve each of the three goals above by using index funds. Index funds are typically very well diversified, with very low costs. And it’s easy to achieve any particular level of risk with index funds. But the above goals certainly can be achieved with actively managed funds. Vanguard, for instance, has a long list of actively managed funds with super low costs.

For many investors — myself included — “simplicity” would also be on the list of characteristics that improve a portfolio. And simplicity is also aided by the use of index funds or ETFs. But I’ve left it off the list because some people truly do not care about it. They’re perfectly happy to manage portfolios with 10 different funds across several different accounts. And there’s nothing wrong with that.

Investing Blog Roundup: Lessons from a Practice Retirement

Housekeeping note: There will be no articles this upcoming week. I’m traveling with family and enjoy the chance to be “unplugged” for a bit. The regular publishing schedule will resume on Monday 7/17/17.

A common piece of retirement planning advice — one that I think is a great idea for people for whom it is possible — is to take a “practice retirement” prior to actually retiring. This week Christine Benz shares the lessons she learned from her own such experiment.

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Good Decisions Can Have Bad Outcomes (and Vice Versa)

If I’m playing blackjack and I choose to hit on 18, I have made a bad decision. Even if I get a 3 and win a bunch of money on the hand, it was still a bad decision — just one that happened to have a lucky outcome.

Point being: A decision is good or bad based on what was known at the time of the decision, not based on how it turned out. In the context of a card game, this is all fairly obvious. But it trips people up when it comes to investing.

Like card games, investing involves a significant degree of randomness. As a result, it’s not rare for good decisions to have bad outcomes or for bad decisions to have good outcomes. Over the course of your investment career, you will almost surely make some good decisions that turn out poorly — or vice versa.

The problem in investing, however, is that people often evaluate a decision based purely on its outcome, causing them to sometimes “learn” a faulty lesson in the process (the equivalent of “learning” that it’s a good idea to hit on 18 in blackjack).

For instance, it’s a mistake for most people to pick individual stocks, given that doing so usually increases risk and reduces expected return relative to using an index fund. Similarly, it’s a mistake to put money into an actively managed mutual fund just because it’s “hot” right now, given that most actively managed funds underperform their benchmark and given that even actively managed funds with winning track records tend not to continue to win.

But either of those poor decisions could actually turn out very well. Of course, in the short-term that would be a good thing. (Can’t complain about good returns!) But it’s dangerous if it leads a person to conclude that the decision was wise and should be repeated.

Conversely, if you have a portfolio of expensive actively managed funds and you decide to move your money into lower cost investments, you’ve made a smart decision. Even if your old portfolio (the portfolio that you abandoned in favor of a less expensive option) happens to perform well over the immediate future, you wouldn’t want to conclude that the change was a mistake.

Overall point: Be wary of doing something just because it’s worked well for you in the past. And be similarly cautious about avoiding something just because it hasn’t worked well for you in the past.

Investing Blog Roundup: No Investor is Fully Passive

On occasion, investors take the “low-cost index funds are good, high-cost actively managed funds are bad” lesson and go a bit overboard with it. I see this periodically in reader emails when a person is considering some particular (thoroughly reasonable) investment decision, but they’re worried that it might “count as active investing.”

As Morningstar’s John Rekenthaler points out this week, we’re all following active strategies, to some degree, with our asset allocation choices. And nobody should necessarily want to be absolutely passive.

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Stop Reading This Blog.

Admittedly I don’t mean for the headline to apply to every reader. But I don’t mean for it to be just “clickbait” either. I genuinely mean that some of you would be better off unsubscribing from this blog/newsletter.

That probably requires a bit of an explanation.

When I started writing this blog in 2008, the whole idea (i.e., “oblivious” investing) was that:

  1. Most people should stop reading/watching financial news, because such sources of information talk constantly about things that have no real significance to a long-term investor, and
  2. Most people shouldn’t check their investments very often, because doing so can cause unnecessary stress about short-term fluctuations.

What I’m coming to realize, however, is that there’s a group of people who would be well served by discontinuing their intake of even “good” sources of investing information (e.g., this blog, the Bogleheads forum, etc.).

Specifically, based on correspondence with readers, I’m coming to realize that there are some people (quite a lot, actually) who find themselves second-guessing their own investment decisions whenever they’re confronted with a conflicting suggestion from a credible source. This personal characteristic combined with frequent intake of investment information can lead to a problematic situation.

In short, if:

  1. You’re already at a point where you know enough to create and manage a low-cost, diversified portfolio that’s roughly suitable for your risk tolerance, and
  2. Reading about investing is making it harder to manage that portfolio (because it makes you constantly doubt your choices)

…then additional reading might be doing more harm than good. (Plus, reading has a cost in that it’s taking up your time.) Of course, the above two points are an evaluation that only you can make. But it’s worth thinking about at least.

One of the most important lessons in investing is that there is no “perfect” portfolio, but there are many “perfectly fine” portfolios. Once you are confident that you have a “perfectly fine” portfolio, just stick with the plan and let the portfolio do what it is meant to do.

Investing Blog Roundup: Why Do Advisors Struggle to Make Simple Portfolios?

In Monday’s article, I offhandedly mentioned that advisors tend to create complex portfolios for clients. Coincidentally, Allan Roth has an article out this week exploring the reasons (both good and bad) for the complexity we often see in portfolios created by advisors.

Investing Articles

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