3 Steps to a Perfect Portfolio

Photo (cc) by brian glanz

Editor’s Note: The following post comes from partner site Dough Roller.

Investing in stocks, bonds or mutual funds can seem overwhelming. Particularly if you’ve never invested in the market, choosing between the thousands upon thousands of investment options can make just about anybody wish for the days of company run pension funds. But like it or not, ever since the advent of the 401k and IRA, we’ve all become (or should have become) investors.

The good news is that putting together a sound portfolio is a lot easier than you may think. In fact, you can construct a solid investment strategy in about 10 minutes using the following three steps.

Step 1: Stocks vs. Bonds

Of all the investing decisions you’ll make, deciding how much to invest in stocks and how much to invest in bonds is arguably the most important. The allocation of your investments between stocks and bonds will determine how much risk you are taking (stocks are generally more risky than bonds). It will also determine in large part how much return on your investment you can expect.

As a general rule, the percentage of your investments in stocks should equal 100 minus your age. So if you are 30, this rule of thumb suggests investing 70% of your investments in stocks (100 – 30). Some take a more aggressive approach and suggest 120 minus your age. Whatever approach you take, the idea is that when you are young and have many years before retirement, you can invest more in stocks. As you get older and closer to retirement, more and more of your investments should move from stocks to bonds.

For our purposes, we’ll assume a 30 year old decides to put 70% of his or her investments in stocks, and 30% in bonds:

Stocks: 70%
Bonds: 30%

Step 2: International Stocks vs. Domestic Stocks

The next question concerns how much of your stock investments should go to foreign companies and how much should be invested in U.S. companies. If you ask this question to 10 different investment advisors, you’re likely to get 10 different answers. While opinions vary, many suggest an allocation to foreign companies of about 20% to 40% of the stock portion of your portfolio. We’ll use 40% for our purposes, which gives us the following rough allocation:

U.S. Stocks: 40%
Foreign Stocks: 30%
Bonds: 30%

And that’s it! We still have to execute our plan (see below), but a simple investment plan that should work for most investors can be developed in minutes.

Step 3: Executing Your Plan

Once you decide on your asset allocation plan, it’s easy to implement it. In fact, there are three basic approaches. We’ll start with the easiest approach.

Lifestyle Funds: Lifestyle funds, also called all-in-one funds, are mutual funds that in turn invest in other mutual funds. By picking the right lifestyle fund, you get instant diversification because the fund takes your money and invests a certain percentage in U.S. companies, foreign companies and bonds. And there is a lifestyle fund to fit just about any asset allocation plan.

Examples of lifestyle funds include Vanguard’s Target Retirement Funds and Fidelity’s Freedom Funds.

Individual Mutual Funds: If you’d like to take a more active role, you can pick your own individual mutual funds. Using Morningstar and other online tools, it’s easy to research mutual funds and determine what asset class a fund covers (e.g., U.S., foreign, bonds). If you spend any time reading about asset allocation, you’ll soon encounter the debate over whether a low cost index fund is better than a higher cost actively managed fund. My vote has always been for the low cost index fund, but either approach can work.

If you take this approach, your best bet is to pick a mutual fund company and stick with it. By investing directly with a company like Vanguard (rather than using a broker), you can save a lot of money on trading fees.

Brokerage Accounts: For even more control, you can implement your investment plan through low cost discount brokers. This approach is best if you plan to invest not only in mutual funds, but also ETFs and individual stocks. I take this approach for some of my investments, and the individual mutual fund approach with others. And that underscores an important point–investing is not all or nothing. You can use a combination of approaches if you’d like, so long as your overall investment plan is consistent with your financial goals.

Going to the Next Level

You can make an asset allocation plan a lot more complicated that what’s described above. For example, you can further divide your investments between large and small companies, emerging markets and developed countries, government bonds and high yield issues, and so on. But for most people, it’s just not necessary. Also, recognize that every situation is different. The above portfolio is for a hypothetical 30 year old; it may not be right for you. If you need help constructing and investment plan, seek out a credentialed investment advisor.

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