I received this question via email a couple days ago:
“What do you think of Vanguard’s Small-Cap Growth Index Fund? Looking on Vanguard’s site, it looks like it has had very good long-term performance (5 and 10 years), and Morningstar gives it 4 stars.
I know it’s an aggressive fund, but I’m a young investor, so I think that might be OK. What do you think?”
I liked this question because it’s a perfect example of a common investing mistake: Building a portfolio backwards by starting with investment selection.
A better way to build your portfolio is to first decide what asset allocation you want to use, then select which investments you’ll use to meet that allocation. After all, a fund can be a great fund, but have absolutely no place in your portfolio.
For example, I think Vanguard’s Inflation-Protected Securities Fund is excellent. It’s a low-maintenance, low-cost way to invest in TIPS. But I don’t use it because I don’t want an allocation to TIPS in my portfolio (because I’m not very exposed to inflation risk).
Choosing Your Asset Allocation
As we’ve discussed before, when choosing your asset allocation, the most important questions are:
- What portion of your portfolio do you want in stocks (as opposed to bonds or cash)?
- What portion of your stocks do you want to be invested in the U.S. (as opposed to internationally)?
After you have answers to those questions, you can move on to selecting investments to meet that allocation.
Or, if you want to, you can further customize your allocation in any of several ways–adding an allocation to REITs, tilting your stock holdings toward small-cap and/or value stocks, including an allocation to TIPS, etc. But you don’t have to.
After you’ve decided what allocation you want to use, it’s time to go ahead and pick funds to meet that allocation. My approach to investment selection involves just two rules:
- In each asset class (U.S. stocks, international stocks, bonds, etc.), select the lowest-cost option available.
- Use as few funds as possible.
When selecting investments, it’s important to remember to view your portfolio as a whole rather than viewing each account as a separate portfolio. By doing so, you can simplify your holdings dramatically (because you won’t need to hold multiple funds in each account), and you may be able to reduce your costs as well.
No Need to Complicate Things
There’s little point in researching a fund unless you’ve already decided that the asset class represented by the fund is one that you want to include in your portfolio. And once you have decided which asset classes you want in your portfolio (and how you want to allocate between them), the portfolio almost builds itself–just keep costs low and keep things simple.