Implementing An Investment Portfolio

So by now you are making smart saving decisions, educated on the types of investments available to you, actively investing in your work’s 401(k) plan, have chosen a discounted online broker, saved enough money outside of work to exceed your “cash buffer”, and have either funded your brokerage account with cash or have transferred your previous investment account from a high-cost provider (please refer to prior sections if this is not the case).

Now, what do we do with the money?

Your investment allocation will stick to our previous strategy of long-term, low-cost, equity investment – but the way you choose specific investments to pursue this strategy will vary based on the amount of money you have.

Investors with less than $10,000 in cash savings

Keep saving. Previously in the “cash” asset class discussion, we went through the importance of having a “buffer” of about 3 months of living expenses or more on hand at all times. This is important since we will almost certainly face unexpected expenses that our regular paychecks can’t absorb, so do not put all of your savings into investments that have volatile prices since you will likely need to use this money at an undetermined point.

But, it is critical that you do not delay contributions to your 401(k), especially if you are eligible for matching contributions. It is also beneficial for you to learn to live with what is left in your paycheck after 5 percent or more of it gets pushed to your 401(k). This gives you time to adjust your living expenses so you know what you can spend after saving approximately 5 percent for your 401(k) as well as saving an additional 5 percent in order to begin funding your personal emergency reserve.

This $10,000 number should be flexible based on where you live and what your monthly expenses are. If you live in NYC, then $10,000 will likely only give you 6-8 weeks to live off of if you lose your job. If you are recently out of college and are still near campus in a house with utilities split six ways, then you can probably start funding your investment accounts a bit earlier.

Whatever you decide your “buffer” to be, keep it steady as you begin to invest. Whether it is cash in your checking/savings account or a cash allocation in your brokerage account – be sure that the total cash amount across all of these areas at least meets your “buffer.” As time goes on, it is wise to gradually increase this level as your expenses will rise.

Investors with $10,000 – $100,000 in savings and investments

Congratulations! You have made difficult saving and budgeting decisions and you now have enough money saved up to begin investing in your personal brokerage account. Or you recently inherited some money, hit a scratch-off lottery ticket … whatever the case we now want to put this excess cash into investments that will provide for long-term growth of our money. If you have no near-term spending goals and these funds are designated for retirement, then it would be wise to maximize contributions to tax-favored accounts like your employer-provided 401(k). Then you can revisit savings towards personal accounts that will have a slight ongoing “tax-drag” on returns due to the taxation of investment income and capital gains each year.

By now we should understand that we want to have diversified investments in equities to obtain the long-term growth prospects involved with company ownership. We also know that it is important to keep our costs low as we try to achieve this investment goal. A great way to do this is through mutual funds or passively managed exchange-traded funds.

If we were to try to diversify our investments by buying 20 individual stocks then we are going to pay up to $100 in trading fees to buy this portfolio of stocks. When you only have $5,000 … this represents an immediate 2 percent haircut on your savings! Instead, with this amount of savings, you may just want to buy several stock mutual funds or exchange-traded funds, which will spread your money across many hundreds of individual stocks (and charge a small annual percentage fee).

Mutual funds are the traditional vehicle of choice for buying the services of a professional money manager to provide you with immediate diversification across many different individual stocks, as well as continuous monitoring of companies held in the fund to determine whether they should be bought or sold. However, in many cases, these professional managers are unable to select outperforming stocks to justify their high fees.

If you work with a broker you could pay up to 5 percent “load” fee, which is charged as soon as you purchase the fund, or “back-end load” when you sell the fund. These funds obviously don’t follow our “keep costs low” mantra, so it is important to avoid all mutual funds with any form of “load.”

There are many mutual funds that fall under the “no-load” category that do not charge an entry or exit fee at the time of purchase or sale. These funds make their money primarily off of an annual management fee that is automatically deducted from your investment based on the percentage of assets you hold in the fund. Mutual funds also charge percentage fees involved with “distribution and service fees” aka “12b-1 fees,” and other fees are often hidden from the casual eye paid to other investment firms for trading costs incurred in the fund. Altogether, some mutual funds can charge over 2 percent each and every year off of your investment!

The easiest solution for immediate diversification with the lowest costs possible is through “exchange-traded funds” aka “ETFs”. These are funds that trade on an exchange like the NYSE and are priced throughout the day as shares exchange hands between buyers and sellers. This contrasts with mutual funds that are only traded at one price determined by the value of the underlying holdings at the end of the stock market trading day.  Certain mutual funds and exchange-traded funds can also fall under the category of “passively managed” funds – meaning that they buy all of the companies that are included in an index (i.e. S&P 500) and just let it ride.

In general, exchange-traded funds are no-load, passive/long-term investments, and have low ongoing management fees, which will be of great use to most young professional investors. Each fund will focus on varying sectors or strategies, so it is important for you to research the management strategy of the ETFs you buy.

Below is a sample portfolio for $10,000 – spread across three low-cost ETFs and with the remaining balance left in the cash option automatically provided by the brokerage firm. Depending on which broker you choose to work with you can determine what ETFs they provide on their platform that are low cost and do not come with trading commissions. The allocation below would be an example of a person with no near-term goals (down payment on a home … knowable near-term expenses (i.e. you’re expecting!) thus someone who is able to invest completely in risky assets and can absorb a temporary price decline (even a significant one).

Description Shares Purchased Share Price Total Value Percentage Weight
U.S. Total Stock Market ETF 145 $53.27 $7,724.15 77.2 percent
Emerging Markets Index Fund 20 $35.12 $702.40 7.2 percent
Developed International Index Fund 25 $56.72 $1,418.00 14.2 percent
Automatic cash option in your brokerage account N/A N/A $155.45 1.5 percent
Total Portfolio Value:  $10,000 100 percent

Notes on each investment choice:

  • U.S. Total Stock Market ETF: Funds in this general category tend to track a broad basket of U.S. companies of all sizes and in all types of businesses. You can obtain diversification to thousands of companies in the U.S. while paying annual management fees to the fund company of less than 0.10 percent in some cases.
  • Emerging Markets Index Fund: Funds in this category generally attempt to track the MSCI Emerging Markets Index. These funds can provide exposure to hundreds if not thousands of individual stock investments in over 20 “emerging” economies – or those economies that show more rapid growth than developed western economies. The largest holdings tend to be in China, Brazil, South Korea, Taiwan, South Africa and India. Funds in this category generally tend to have higher expense ratios than U.S. market indices but should be below 0.80 percent.
  • Developed International Index Fund: These funds generally attempt to track the MSCI EAFE Index – or an index that follows stocks in more developed (larger and slower growing) economies in Europe, Australia/Asia and the Far East. This investment type can provide exposure to a broad category of businesses in countries like Japan, U.K., France, Switzerland, Australia and Germany. Expense ratios tend to be somewhere between broad U.S. market index funds and emerging market index funds.
  • Cash: You do not have to do anything to enter into your cash investment. Once you deposit money into your brokerage account it will automatically move into the account’s cash-sweep investment vehicle. In this portfolio, this represents the money left over from what you didn’t use in purchasing the other three investments.

Notice how the portfolio is roughly set in a percentage basis: Roughly 75 percent U.S. stocks, 15-20 percent developed foreign stocks, 5-10 percent foreign emerging stocks, and 0-5 percent cash. Portfolios of different sizes will require some basic algebra to determine the number of shares to buy based on the asset level to roughly mirror these percentages.

A portfolio made of these types of funds could provide stock investments in more than 3,000 companies of all sizes across the globe. Trading fees could be below $30 and in some cases $0, you will see no annual fees if you chose the correct custodian, and on average, the funds should see an ongoing management fee of less than 0.40 percent (incredibly low by industry standards). This is a great example of inexpensive and broad diversification amongst some passively managed equity funds.

Each brokerage firm’s site will have detailed tutorials or experts ready to talk and help you navigate where to go to enter the required information to trade in the account. Select the “market order” button when buying or selling, which means immediately place the trade based on the current price instead of a “limit order” which says wait until the price hits a certain mark before you place the trade. One option in the trading screen of note is the “reinvest dividends” button. You can choose to have your broker automatically buy more shares of each fund whenever they pay a dividend – so instead of getting a cash dividend payment, you will just increase the number of shares you own in the fund. Normally it is best to have dividends build up in cash and you can invest those balances as they grow and as you add additional funds to your account.

Remember – the above represents a fictional example of an investor with no near-term goals or one who does not definitely need the money within 10 years or so. If it is the case that you know you need money in several years to meet a goal, then you should make your investments less aggressive. Above we allocated the entire account (excluding a small cash balance) to stocks. If you need to take a more moderate approach to preserve some assets for near-term usage then you can consider adding a fixed-income allocation.

Description Shares Purchased Share Price Total Value Percentage Weight
U.S. Total Stock Market ETF 100 $53.27 $5,327.00 53.3 percent
Emerging Markets Index Fund 15 $35.12 $526.80 5.3 percent
Developed International Index Fund 15 $56.72 $850.80 8.5 percent
Aggregate Bond Fund Index 25 $108.02 $2,700.50 27.0 percent
Automatic cash option in your brokerage account N/A N/A $594.90 5.9 percent
Total Portfolio Value:  $10,000 100 percent
  • Aggregate Bond Fund Index: This is a type of fixed income exchange-traded fund. These funds can provide exposure to thousands of individual bonds including corporate debt, mortgage-related debt, and U.S. Treasury debt while only charging an annual expense ratio in some cases of below 0.20 percent annually.

Note in this example we now have a cash and fixed income allocation of about 30-35 percent worth about $3,300. The fixed-income allocation is still at risk of price declines in the case of rising interest rates and/or declining credit quality, but it is much safer than the stock investments and will likely see less price volatility in the near term. If you have an expense that is several years away, then beginning to build a fixed income allocation for that event is wise. If that event is within 3 years then move more of your risky investments (stocks) into safer investments (cash or fixed income). If the event is within a year or two then you should have the majority of the money required for that event in cash. Once there are no more major events on your horizon it is wise to remember our investment horizons are very long – and near 100 percent equity allocations are favorable for these time frames!

 

Investors with $100,000 – $200,000 in savings and investments

As we build the size of our portfolio through gains over time and continued savings and reinvestment we may want to consider an alternative option of equity investing compared to the exchange-traded fund strategy used in the prior section. The main deterrent from buying individual stocks with a smaller portfolio was that we didn’t want to incur the trading costs of spreading our money across many individual stocks. We also didn’t want to only hold a few individual stocks since we would face risks of being undiversified should one of our stock holdings face unforeseen troubles, thus potentially causing us to lose a large part of our total investment.

Though one would be fine holding the portfolio of ETFs for quite some time as our investments build up, there are several potential advantages to buying a diversified portfolio of individual stocks instead of holding ETFs:

  • ETFs are made to cover the entire equity spectrum – including the sectors that may be currently overvalued or that may have limited long-term growth prospects.
  • They are also designed to include all companies within a sector, even those that are likely on a long-term decline.
  • By design, many ETFs are made to track stock market indexes like the S&P 500 or a broader market measure that includes smaller companies as well. Indexes are usually designed to give the most weight to the highest valued companies, also known as a market capitalization weighting. Therefore, the currently largest and most successful companies in the world and their share performance will have a more significant impact on the index (and thus the ETF’s) price movement. This goes against the timely investor creed of “buy low, sell high” – by buying an index fund you are basically buying a larger stake in companies that are currently at a higher valuation relative to the stock market.
  • It is extremely difficult to pick individual stocks that outperform an index over the long-term – but if you buy a fund that tracks an index (before they charge their fees) then you are guaranteed that you will underperform the index after fees.
  • By buying companies directly you can lower ongoing fees from the ETF or mutual fund, and be able to manage the account more tax-efficiently by harvesting capital losses and avoiding a sale of your most appreciated stocks.

    This is not to say that the exchange-traded fund strategies in the prior section are not good investments – it is more so that once our portfolios grow we may be able to grow into a new strategy. If you are not comfortable with the additional risks of selecting individual stocks on your own then you will be fine growing your portfolio with ETF investments. If you have more experience and a larger portfolio, then selecting individual stocks might be a favorable strategy to keep diversified and lower the ongoing portfolio management costs.

There are several important factors to keep in mind if you choose to select individual stocks while you are building a portfolio:

  • A well-diversified stock portfolio will consist of 25-30 individual stocks of large and medium-sized firms spread across the major sectors of the U.S. economy. You want to buy companies across the different sectors of the economy to reflect the current economy so you are not essentially placing a bet on which type of company will succeed going forward. Placing a bet on a sector can cause your performance to vary greatly from the market, which can set you up for a large underperformance.
  • No individual stock should hold over a 4-5 percent allocation in the portfolio in order to prevent a significant overall loss to the portfolio should a company enter into unforeseen troubles and wipe out shareholders (as seen in prior examples of Enron, WorldCom and Lehman Brothers).
  • It is wise to continue using mutual funds and exchange-traded funds to maintain diversification to foreign and emerging markets, as well as smaller domestic companies.

As with the previous example – if you had a near-term goal then you would lower your percentage allocations to stocks and increase it to bonds and cash. The actual percentages will depend on the size of your commitment and the distance to it. If you have a $50,000 portfolio and needed $10,000 for a down payment in 5 years then right now you might put $5,000 in a fixed income fund. Over the next few years you would gradually increase that position, and once the payment is only a year or two away you would begin moving that fixed income allocation into the ultra-safe cash position.

Once the down payment (or any other event) is passed, then your portfolio could return to a near 100 percent stock allocation (with a cash “buffer”) in order to achieve long-term growth. Your situation will be unique, so do your own research and choose your investments carefully! If you do not have experience with analyzing the financial health of a company, then you can either hire a professional to pick individual securities for your portfolio, or you can continue to invest with low-cost mutual funds or exchange-traded funds.

Investors with more than $200,000 in savings and investments

As your investments build to this level (which it most assuredly will over time if you take the right steps and have patience!) and as we age our financial picture becomes even more complex. With larger sums of money and the more complex life situations that will arise in the years ahead at this point, it may make sense to employ a full-time financial planner. Having a financial advisor will provide you with a concrete long-term financial plan for your path to retirement, a strategy for college savings plans for your children, strategies for buying life insurance, a counsel for tax strategies, and a way to discuss and plan for many other events with your investments that are no longer generic but detailed specifically for your situation.

Generally, young professionals do not have enough money to meet the minimums a financial planner requires, and our financial picture is not complex enough to merit paying someone to help us work through it. As you approach $100,000 – $200,000 in investable assets then it may be time to find someone with whom to start a long-term financial relationship.

It is still key however to keep your costs low! Look for a financial planner that is “fee-only,” or one that charges for their services with an annual fee stated as a percentage of your assets. Anything above 1.00 percent annually is too much! The importance of a “fee-only” planner is that you don’t want an advisor that charges for their services every time you place trades or one that will be consistently trying to sell you financial products to increase their compensation. In a fee-only arrangement, your advisor will benefit when you benefit – if your investments see long-term success then your advisor will benefit as well!

Look for an advisor that is a “Registered Investment Advisor” (RIA), which means the advisor registers with the Securities & Exchange Commission as an advisor who holds a fiduciary duty to their clients. Serving as a fiduciary means that an RIA is required by law to work in your best interests at all times. This way you know that they are consistently providing you with the best solutions, for you! Almost all RIAs are fee-only providers, but not all fee-only providers are RIAs.

Also, look for an advisor that holds a professional designation. This shows that they are dedicated to the field of financial planning and have serious experience that will likely allow them to provide you with the best advice. The most reputable designations (among many out there) include the Chartered Financial Analyst (CFA) and the Certified Financial Planner (CFP).

Perhaps most importantly is that you should look for someone you get along with and you can trust and feel comfortable with when talking about very detailed aspects of your life – be it financial or personal! It is critical that you can and will talk to your advisor about anything that impacts your financial picture or about anything that you want to achieve so you can modify your finances to reach that goal.

Talk to your friends and your parents and see if they will refer you to an advisor that they have had a great experience with (as long as they are an RIA and fee-only). Or, use the following website www.investmentadvisorsearch.com to search through almost 30,000 RIA offices for an RIA-based on location and how much money their firm manages.

Parsec Financial Management, Inc., the presenting sponsor of this site, is a fee-only Registered Investment Advisor with North Carolina offices in Asheville, Charlotte, Tryon, Winston-Salem and Pinehurst. However, we work with clients across the country and we would be glad to talk to you about your specific situation at any point along the way in your career. Visit parsecfinancial.com to learn more.

Ongoing portfolio maintenance:

Here we are going to provide some notes that apply to portfolios of all sizes. Since they don’t neatly fall into unique categories, we’re just going to lump them all under “ongoing portfolio maintenance.” These are tips to help you monitor and control your portfolio of investments after you have established your initial investment allocations with your discount provider.

Continued deposits:

You aren’t done if you have just set up your online accounts and invested them appropriately with the money you have right now. You must begin early and keep saving and investing at all times if you want to continue to build the size of your portfolio! The best way to do this is to make it automatic so you don’t have to think about it. Set a recurring draft from your checking account to your brokerage account each month to make the process automatic. Then go invest those funds in your brokerage account as deposits and investment income build up your cash balances.

Monthly Statements:

Read your statements that will come monthly from your broker. Sign up for online delivery of these statements and all other forms of communication (trade confirmations and company annual report deliveries) since the amount of paper used in these mailings is beyond excessive. Plus, some online providers will actually charge you if you choose paper delivery. Stay informed with how your investments are doing by reading these statements.

Rebalancing:

Over time certain investments will outperform others, and eventually your portfolio will have different weights assigned to the stocks/ETFs you initially purchased. In our previous example of a fictional $10,000 portfolio, for example, say over a year your emerging market funds greatly outperformed your other funds and your portfolio now has a 20 percent weight to the emerging fund instead of the original 10 percent. This would be a great time to sell some shares and spread that money into the U.S. index and the other foreign developed nation index that may have recently underperformed.

Or if you hold a portfolio of stocks and after a year one stock now holds a 7 percent position – it might be wise to sell 25-30 percent of that investment and buy shares of a company whose price has underperformed (yet still has promising long-term growth prospects).

By occasionally selling portions of your best performers and redistributing that money into other investments you are following the “buy low, sell high” mantra in a great way. The important thing to remember, however, is that you don’t want to rebalance your investments often since you will increase your trading costs and you will face higher tax rates if you sell your investments you have held less than a year. Federal taxes due on the gain when you sell a stock within a year of your purchase date are calculated based on your marginal tax rate (ranging from 12 to 37 percent), while federal taxes due on realized gains when you sell a stock you have held for more than a year are assessed at long-term capital gains rates of between 0 and 23.8 percent (as of the 2018 tax code).

Short-term trading and market timing in your account:

Avoid it. We’ve covered this before, but wanted to re-emphasize this point. Media outlets like CNBC will try to fill their full day news blocks with information that they suggest should make you, the individual investor, modify your investment strategy. Of course, if they said “this news is good to know, but it really doesn’t affect your investment strategy and it requires no action from you”… then viewers would probably tune out.

If you do not have the time or interest in ongoing account maintenance then you can consider working with a “Robo-Advisor” like Wealthfront or Betterment that can automate a lot of the rebalancing and investing options for you at a small fee. It is important, however, to make sure that your investments targeted for long time frames are allocated to 100 percent equities. These providers will gather data from you electronically and make investment recommendations that may be too conservative. This could result in lower returns over long time frames relative to an all equities portfolio.

Set a solid investment allocation that fits your goals, continue to add to your investments through monthly deposits, rebalance your investments on occasion, but do no more than this. Keeping your portfolio stable and boring is likely the best option for young professional investors.