Before I break it down, let’s restate our assumptions:
We are investing for long, not short term returns
Why else would you be reading this blog...
We will never be able to pick good individual stocks from bad ones.
More of an evidence-based conclusion.
We are in the 25% tax bracket (income of $36,251–$87,850)
The average American is, but if you aren’t, I will cover the implications of taxes in a later article.
The USA will recover from any catastrophe before we retire.
If you don’t assume this, you should not invest in US stocks or bonds.
Cheap funds will continue to outperform expensive funds as they have in the past.
More of an evidence-based conclusion, but we are assuming this will stay true in the future. For this assumption to be proven false, fund managers will have to beat the market.
The implications of different tax statuses and IRAs I will discuss later. For now, just remember that stocks are taxed only when you sell them at a gain (called realizing capital gains), and more when the shares are less than a year old. This is a huge incentive to realize capital gains as infrequently as possible.
Under these assumptions, we can exclude active managed funds from consideration, as they have very high expense ratios. These leaves us with mostly stock funds indexed to a certain market and left alone, aka index funds.
Instead of listing actual categories, I will list the key words to look out for. Sometimes you will find these used in conjunction, e.g. International Value FTSE Index Fund.
Index: Passive-managed fund. Much cheaper than Active-managed funds. All stock and bond funds are one or the other.
Balanced: Euphemism for active-managed.
International: Excludes US stocks. More expensive than US stock funds (.1% vs .05% expense ratio for my funds). Slightly more tax-efficient than US stock funds.
Large/Mid/Small-Cap: This fund is exclusive to companies of a certain size. Smaller companies are higher risk & reward. Small-cap is in vogue right now, but I'm not a trendy investor. Cap stands for Capitalization. They are all priced similarly.
Value: Includes undervalued stocks that tend to grow slow. A stock's value is determined by the Cyclically Adjusted Price to Equity ratio (CAPE).
Growth: Includes stocks that tend to grow fast. Riskier than Value funds.
Blend: A blend of Value and Growth stocks.
Tax-exempt: Self-explanatory. Ignore these funds unless you pay very high taxes, as tax-exempt assets tend to have very low growth.
Tax-managed: Not necessarily active-managed, these funds minimize dividends. I don’t understand these well enough to be interested in them.
What Should My Stock Allocation Be?
Stock funds are just a collection of stocks, whose performance can not be predicted, so it shouldn’t surprise you that we can’t predict the performance of stock funds accurately either. There’s really only two big principles we know:
1. Risk is correlated with return. Risky funds should outperform safe funds in the long-term, but are more volatile.
2. Cost is correlated with return. Low-cost funds should outperform high-cost funds in the future.
Example Allocation: Betterment
If you decided to invest with Betterment, you can find this chart on the Allocation tab. Set stocks to 100% to view Betterment’s stock allocation
Take a minute to scrutinize this. How risky do you think Betterment’s stock funds are? Let's examine this.
International stocks (yellow and coral) are 35% of their total stock portfolio, a reasonable amount (brokerages are advising people hold at least 25% in international). Most of this is in developed markets as opposed to emerging.
Large-cap stocks make up most of their US stock holdings, but they have some small and mid-cap stocks as well.
Overall it’s a pretty balanced portfolio as one would expect from Betterment’s one-size-fits-all approach.
Teach Me How To Invest Like This
Learn these terms and decide how risky you want the risky part of your portfolio to be. In the next article, I will teach you how to invest with more precision than I did in my Beginner Investing article. You’ll need at least $3,000, preferably $10,000, but $20,000 would be even better.