Hey hey, and welcome back to lesson 2 of Minafi’s Minimal Investor course!
Lesson 1 Review – Accounts in Order
Before jumping in, let’s review lesson 1. In lesson 1, you did four key things:
Make a list of all accounts you have.- Made sure you can log in to each of them.
- You figured out which investment account type(s) to use for this course (401k, Roth IRA, IRA, Brokerage).
- Opened a company 401(k) account or a Vanguard Account.
We won’t make any new investments in this lesson. Instead, we’ll focus on picking funds and deciding how much to invest in each.
If you haven’t completed all the steps from lesson 1, that’s OK. There are still a few lessons before you need those accounts open. If you’re still waiting on your HR department to set up your 401(k), or waiting to link your bank account to your investment account – don’t worry, you don’t need those yet.
We won’t buy any funds until lesson 4, so you still have some time to open one up (and please, open a Vanguard account).
That said, let’s jump into lesson 2!
Lesson 2 Overview
The next goal is getting to an understanding of how to evaluate funds. If I just gave you recommendations, then you’d have to trust me. That’s the relationship most investors have with their financial advisors! We want a different route – one where you understand every investment.
Because of that, the next three lessons will focus on learning what and why. It’s also important to know that there is no “right” way to invest. The strategy used in this course will focus on a few things:
- Reducing taxes by buying for the long term in the right accounts (lesson 1)
- Reducing market swings so that your funds aren’t fluctuating wildly (this lesson)
- Reducing risk by diversifying your funds (this lesson)
- Reducing fees by picking low expense ratio funds and not using a financial advisor (lesson 3)
We already accomplished #1 in the first lesson. The goal of this lesson is to understand the power of diversification in an investment strategy. By the end of this lesson, you should know why some investments are far superior to others for long-term investing. This lesson should help points (2) and (3) on the above list. Here’s the rundown of how you’ll get there:
- Understand market sectors
- Take a look at market categories
- Look at how diversification helps in a downturn
- Learn the difference between investment types
I’m burying the lead here but…
Most important of all, you’re going to understand why you only need three funds to invest in the entire market. This approach is called a 3-fund portfolio, and it is the most basic diversified portfolio you can create. When I say “3 fund portfolio,” you’ll know what that means, and why it invests in the entire market.
1) Understand what market sectors are
Do you remember the “dot com boom” in 2000? Technology is the market sector that collapsed the most during that period. In 2008 during the Great Recession and housing crisis, what cratered was a combination of the housing sector and the financial industry.
“Sectors” are groupings of companies in the same industry. Every company belongs to only one of these sectors. In the investing world, we group these sectors into a select few:
- Financial – Bank of America, Wells Fargo
- Technology – Microsoft, Apple, Google, Facebook
- Consumer Discretionary – Retail, consumer services
- Consumer Staples – Food, beverages, Essentials
- Energy – Oil, gas, power
- Health Care – Hospitals, insurance
- Industrials – Aerospace, defense
- Communications – Phones, Internet, Cable
At different times, different sectors will be booming or busting. While I firmly believe that technology helps improve the human condition, that doesn’t mean every company in that sector has a sound business plan. Luckily, you don’t need to evaluate each company to pick the winners – there’s a less time-consuming way: Index funds.
Zach over at Four Pillar Freedom created a great graph illustrating the performance of these sectors over time:
Each sector has wildly different returns (the X-Axis). The Y-Axis represents how wildly the price fluctuates for companies with that sector – which showcases how different they are.
There’s one spot on this graph I want you to focus on: Total US stocks. This circle is the key to most of what we’ll discuss in this course. That one point represents a portfolio with a little bit of every sector. It has better returns than most just about anything with much less risk (measured by standard deviation).
What are you drawn to on this list?
Imagine you have $100, and you want to invest it in these sectors. How would you allocate your funds?
You would likely use all the information available to you to select an allocation that optimizes results. Here’s the kicker: there will always be people who know more information than you.
You may decide to put your investment in the Finance sector – but are unaware that the current student loan crisis is about to bring all banks to their knees (I’m not saying that will happen, but just as an example).
A fully informed speculative investor would know the pros and cons of investing in each of these sectors. It’s a never-ending chase to find and parse all information publicly available.
My strategy is to not worry about these facts – and you don’t need to either! There are always more facts, news, and information to consume. You could spend every hour of every day reading up on the latest company news and still not make the right decision at the right time.
Instead, imagine an allocation of that $100 that puts some money into every group. By doing this, you’ll never hit the lottery investing in the winner for a given year, but you’ll also never be the biggest loser either.
This strategy is called market sector diversification. Doing this means that if any specific market sector takes a plunge, you won’t lose your shirt.
Takeaways
- Market sectors are groups of companies like Technology, Financials, and Telcom.
- Investing in specific stocks or sectors implies you know more than everyone else about that, and is usually wrong.
- Market sector diversification means investing a little bit in each sector.
2) Take a look at market categories
Market sectors are made of companies within a specific industry. Market categories are a much more broad term that includes companies from multiple sectors. Here are the base market categories.
- Large-cap – Very large companies ($10+ billion)
- Mid-cap – Medium companies ($2 – $10 billion)
- Small-cap – Smaller companies (under $2 billion)
These three are called market capitalization and are based on the market cap of the company. There are many more small-cap companies, but large-cap companies are tremendously large.
Another way to group companies is by where the company is in its life. Younger companies or ones that are reinvesting a lot of money into research and new products are “growth” companies. These companies are taking on more risk in hopes of entering into new markets or creating new products. Value companies focus more on doing what they do better and more optimized.
- Growth Stocks – Companies that expect to grow in the future. The share price takes into account future growth (ex: Apple, Amazon, Facebook, Disney)
- Value Stocks – Stocks that are priced well for the earnings the company is making (Microsoft, Johnson & Johnson, GE)
- Mix – If the fund doesn’t say growth or value, it’s likely a mix of both
Most investors will tell you value stocks are the most stable. They’re the kind of companies Warren Buffet recommends. However, they also require tremendous research to understand! Like with market sectors, it’s better to just invest a little bit in each of these market categories.
If we laid out these two metrics – Market capitalization and company growth, we’d create a grid like this:
You’ll see this nine-quadrant grid a lot. Every company can fall somewhere in here.
The Easy Way
That’s a lot of groupings of funds! The easiest way to invest in this entire group of funds is a single “target retirement date” fund. These funds typically invest funds between US Stock Market, International Market, and Bond markets in just one fund.
You could invest in just one fund, like Vanguard Target Retirement 2060 Fund, and be completely diversified. This fund invests in:
- 55% US Stock Market
- 35% International
- 10% Bonds
This fund targets people who hope to retire in the year 2060 and each year will adjust these percentages. Compare that to the Vanguard Target Retirement 2015 Fund allocation:
- 26% US Stock Market
- 17% International
- 57% Bonds
In both examples, the US Market to International ratio is about 66/33%, but the Bonds number grew a ton!
If you only have a 401(k) and are starting to invest, these funds are an excellent way to achieve a diversified portfolio! They do a lot of the work for you of rebalancing and let you focus on just saving money.
If you have multiple accounts I don’t recommend these funds for four reasons:
- You can’t control what percent of your funds is in which market class.
- The fees associated with target retirement funds are slightly higher than doing it yourself. (we’ll look at fees in lesson 3 – fees)
- This doesn’t allow you to place your funds in the most tax-advantaged account (we’ll talk about this in lesson 4 tax-efficient investing).
- If you want to change that, you’ll need to sell the entire fund and pay taxes (we’ll get into taxes in lesson 8 taxes).
“So then how do I invest in these?”
The easiest way I’ve found is through a Simple Three Fund Portfolio at Vanguard. We’ll be going over some of the content in this article in future lessons, but the
You can invest in 3 Vanguard funds and effectively be invested a little bit in everything going on in the world.
That’s a bit extreme, but between 3 funds (which are in that article) you’ll be invested in 18,126 different things!
Takeaways
- The 3 main market categories are US Stock Market, International Market, and Bonds
- If you invest in 1 fund in each group you can have a diversified portfolio.
3) Look at how diversification helps in a downturn
We’ve looked at what diversification is, but not why it’s awesome. Take a look at the following chart. Each box represents a Market Category or Market Sector.
You’ll notice that no market category or sector is consistently at the top. Emerging Markets have a good run in the mid-2000s, then fall off fast. Real Estate has an excellent rebound from the recession but then falls off quickly.
Trying to pick a winner in a market is a waste of time. Even experts can’t do it reliably.
Financial advisors, Warren Buffet, and I prefer something different: invest a little bit in every class. With that asset allocation, you’ll end up somewhere in the middle.
Do you notice the “You” box that’s consistently in the middle of the pack? That’s a portfolio made up of 20% bonds. By diversifying between all of the assets, you’ll always be somewhere in the middle.
Takeaways
- By diversifying your investments, you’re guaranteed to be in the middle of the pack.
- Diversifying investments means fewer fluctuations to your account balance.
4) Learn the difference between investment types
“How do you invest in a market category?” is the next question. That’s where ETF and mutual funds come into play. ETF stands for “Exchange Traded Fund.” These are funds that invest in a bunch of stocks (and other things).
Imagine a fund (in this case Vanguard Total Stock Market Index) that fund invests in over 3,493 different stocks in small portions. You don’t need to invest in those 3,493 on your own – you just pick one fund, and it invests in thousands of companies for you. The most this fund invests in a single stock is 4.84% – in Microsoft.
Vanguard Total Stock Market Index (VTSAX) consists of these market sectors:
The amount invested in each market sector isn’t the same, but that makes sense! These proportions mirror all of the companies in the United States. By investing in a single broad-market fund like $VTSAX, you invest in small, medium, and large companies. You also invest in growth companies, value companies, and blend companies.
What Next?
We’ve talked about stocks and ETFs, but what about mutual funds? Well, mutual funds are the same as ETFs for the most part. Mutual funds also consist of multiple stocks or other funds.
Honestly, I haven’t needed to draw a significant distinction between mutual funds and ETFs. Vanguard has an excellent article on the differences between them if you’re curious. I also wrote an article comparing them.
One big difference is that stocks and ETFs trade on the stock market. When you buy or sell an ETF or company stock, the exact value may fluctuate depending on when your trade goes through.
Mutual funds are bought and sold at night after the market closes. Because of that, you don’t need to worry about the specifics to perform a trade in real-time. You schedule a mutual fund purchase or sale, and then it executes when the market is closed.
I prefer mutual funds myself. There’s less chance for something to go completely wrong with a trade since the prices are locked in at the close of business. The downside to this is that you can’t instantly sell at any time. With mutual funds, when you sell the trade won’t go through for another 24-36 hours. I sell funds so rarely that mutual funds end up being the best way to not worry about the specifics and invest for the longer term.
Bonds
The last of the primary investment types is bonds. Bonds are financing someone else’s investment. Take a mortgage, for example. You borrow $250,000 at 4% interest. You are paying someone 4% for the privilege of borrowing money. Bonds work in this same way, except the borrowers range from governments to stable businesses to less reliable players. If stocks are an investment in a company, bonds are an investment that someone will pay back a debt.
Bonds tend to be much safer than stocks, and are an essential part of a diversified portfolio.
How do you buy bonds?
Bonds aren’t something you just go to the bank and pickup. Instead, the best way is to buy an ETF or a Mutual Fund that invests in thousands of bonds. Because of this, if a single bond isn’t paid back, your investment won’t see a noticeable negative change.
Takeaways
- Stocks are the most volatile investment
- Mutual funds and ETFs both invest in a bunch of stocks and other funds
- Bond funds invest in a bunch of bonds.
Lesson 2 Recap
That was a lot, but you made it through! This is a DENSE lesson. Diversification is the base that forms the foundation for how you invest. It’s why you’re able to invest in only three different funds. It’s how you can sleep well at night in the knowledge that your investments aren’t all in one basket.
You learned market sectors are groups of stocks like technology or financials. You learned market categories include stocks in a specific market. You learned the difference between stocks, ETFs, Mutual Funds, and Bonds.
One recommendation before the next lesson is to read about The Simple Three-Fund Portfolio at Vanguard. If you just want advice on what to do, you could use this approach right now. In the next few lessons, we’ll dig into how to minimize your fees, minimize your taxes, and learn how to rebalance your accounts each year.
Next Lesson
With our understanding of the diversification down, the next lesson will focus on how to minimize the fees you pay to invest. You’ll be able to look through the funds at your 401(k) and figure out exactly which ones have the best fees. We’ll do this with an eye for market sectors, market classes with a diversified portfolio in mind. The goal of the next lesson will be to understand how to look at a list of funds and know how to be able to pick out the best ones.