You’ve heard it over and over, “Diversify your investments!” But how exactly do you do that? And how can you do it without getting complicated? This simple guide will show you how to diversify your investments with only three funds.
Keeping It Simple & Low-Cost
I’ll be the first to tell you that this is not an “optimal” portfolio. It’s not the best, but it’s a lot better than a lop-sided portfolio full of high fee funds. There are some costs to using a simple plan for your investments. First, it’s not quite as diversified as it could be. And second, there could be better ways to structure your portfolio for lower costs. (Though it’s unlikely you’ll find significant cost savings over the portfolio I’m about to share with you.)
I say it’s unlikely you could lower your costs because I’ll be using index mutual funds from Vanguard in this sample portfolio. Index funds have much lower costs than actively managed funds, and Vanguard is almost always the leader in low-cost index funds. They also continue to take steps to keep their costs low and remain at the top of the pack. Costs are important because they eat into your investment returns and have been shown to be the best indicator of future performance. Without further ado, here’s the portfolio.
The Stock Portion
The stock portion of this very simple, diversified portfolio contains two funds designed to give you broad coverage of the U.S. and non-U.S. stock markets. You’ll simply take the amount of your portfolio you want in stocks and split it evenly between these two funds. Simple. Easy. Fast.
Vanguard Total Stock Market Index
Ticker Symbol – VTSMX or VTSAX
Fund Number – 0085 or 0585
Expense Ratio – 0.18% or 0.07%
Minimum Investment – $3,000 or $10,000
This fund holds over 3,400 U.S. stocks. It has big names like Apple, GE, and Procter & Gamble, but it also holds small companies you’ve probably never heard of. Because of the way it’s structured, it holds more of the bigger companies than the small ones. But you’re still getting a piece of all these different businesses.
The reason I listed two sets of information above is because Vanguard offers two share classes for this fund depending on how much you invest. You need at least $3,000 to buy the Investor share class (VTSMX) and $10,000 to buy the Admiral share class (VTSAX). They’re the exact same fund but the Admiral shares have lower annual expenses.
Vanguard Total International Stock Index
Ticker Symbol – VGTSX
Fund Number – 0113
Expense Ratio – 0.32%
Minimum Investment – $3,000
This fund holds nearly 1,800 non-U.S. stocks. You’ve probably heard of Nestle, GlaxoSmithKline, and Toyota, but it also contains stocks from smaller international companies and companies in emerging markets (like China and India). These stocks move a little differently than U.S. stocks, so it will help smooth out your investment returns.
Unfortunately, Vanguard doesn’t offer Admiral shares for this fund yet. I’m hoping they will sometime soon, so keep your eyes open. The reason the costs are higher than the U.S. fund is because there are higher costs involved with investing overseas. However, Vanguard charges 77% less than similar mutual funds for these kinds of stocks, so it’s still a great deal.
The Bond Portion
I’m only suggesting one fund for the bond portion of this portfolio. Why? Because this should be the safe portion of your investments. There’s no need to get fancy with your safety net. So we’ll be choosing a fund that will keep your money safe and move very differently than stocks.
Vanguard Short-Term Bond Index
Ticker Symbol – VBISX or VBIRX
Fund Number – 0132 or 5132
Expense Ratio – 0.22% or 0.12%
Minimum Investment – $3,000 or $10,000
This fund holds well over 1,200 different bonds. Most of them are U.S. Treasury obligations (72.5%), which are backed by the full faith and credit of the U.S. government. If these go unpaid, you’re going to have bigger concerns than what happened to your investment portfolio. These are considered the safest of bonds. The rest of the fund holds bonds from finance companies, industrial companies, some foreign issuers, and a few others.
The reason I recommended a short-term bond fund is because it limits your risk in case interest rates change. If you go with intermediate-term or long-term bonds, you risk losing money if interest rates go up. Short-term bonds mature fast enough that their prices remain fairly stable through most economic conditions.
Like the Vanguard Total Stock Market Index Fund, this fund offers two share classes based on your investment. This is one of the lowest cost bond funds you’ll find anywhere.
The Bottom Line
With just these three funds you can put together a portfolio that owns a piece of over 6,000 different investments. And remember what I said about low costs? Let’s check out an example.
Let’s say you want to put 2/3 of your money in stocks and 1/3 in bonds. That means you’ll simply split up your money evenly between these three funds. (I’m keeping this asset allocation simple on purpose.) You’d need at least $9,000 to do this so you’d meet the fund minimums. If that’s all you have to invest, your portfolio will cost you 0.24% or about $21 the first year. The expense ratio is your only cost because there are no commissions to pay when you invest directly at Vanguard.
If you have at least $30,000 to invest, you’d get lower expenses because you would qualify for the Admiral shares. Now your portfolio would cost you 0.17% or $51 for the first year. For that tiny price you can own a piece of over 6,000 investments. I’d say that’s a pretty good deal!
The Problems with This Portfolio
As I said before, this isn’t the best investment portfolio you could have. You’re not going to have much exposure to small companies in this portfolio. I would also recommend tilting your portfolio toward the value side of things (think of stocks that are “on sale”). But for simplicity and general diversification, you can’t beat this portfolio.
photo credit:(Michael on Flickr)