Personal Investing: 4 Reasons Why 3 Funds Are All You Need

I’d guess that many of the monkeys here were attracted to finance initially because of an interest in stock investing. Maybe you received some shares as a gift when you were young, or you wanted to become the next Warren Buffet, or you just enjoyed the challenge and potential rewards that come with picking winning stocks.

My parents were not financially adept enough to get me interested in investing at a young age, and the first finance book that I read was A Random Walk Down Wall Street, which effectively immunized me against making too many boneheaded financial decisions.

After devoting a decent chunk of time over the past couple of years to reading about different investing styles, however, I decided to just stick to low cost index funds. And probably no more than 3—here’s why…

1. It’s easy to be well diversified.

With just three funds, you can easily get exposure to US stocks, bonds, and international stocks. Sure you can add other assets…but is it really necessary when just three funds will give you access to thousands of securities at once?

Many "Bogleheads"—a group of investors who favor index investing as inspired by Vanguard Group founder John Bogle—suggest a three-fund portfolio consisting of the U.S.-focused Vanguard Total Stock Market Index fund, Vanguard Total International Stock Index, and Vanguard Total Bond Market Index . Together, the three mutual funds, which also offer ETF shares, track more than 15,000 global securities.

2. There's less to worry about.

There’s a wealth of literature from the world of behavioral economics which tells us that more choices can actually overwhelm us and lead to sub optimal results. Focusing on sticking to an asset allocation and re-balancing every year is difficult enough for many people—why muddy the water with trying to add more funds than you absolutely need?. See here: here:

Experts also are quick to point out that even a simple portfolio needs tending—investors shouldn't just set it and forget it. "The biggest pitfall [for all investors who decide on an asset mix and invest accordingly] is behavioral, when people don't want to rebalance," says Brad McMillan, chief investment officer at Commonwealth Financial Network in Waltham, Mass., and San Diego. For instance, if equities have taken a hit, you should consider buying more equities and selling off other asset classes, and "that's extraordinarily hard to do," he says.

3. They perform well.

If you get market returns and manage to save on transaction fees and on management fees, you’ll likely beat most other investors anyway. See here:

Investors don’t need to try and “beat the market.” Investors only need to match the market, something that is surprisingly difficult to do. In a column on How Did Your Portfolio Perform in 2010? I suggested ways to compare the return of your portfolio with the return of the market. It isn’t quite as easy as it seems, and financial advisors often want to compare portfolios they manage to benchmarks that are not a valid comparison. Take time to do this calculation and you may be surprised at how your portfolio really isn’t performing as well as you thought.

4. Active investing is hard.

You probably won’t be the next Warren Buffet.
But you can take his advice:

Even Warren Buffett recommends that “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.” (Warren Buffet, Letter to Shareholders, Berkshire Hathaway Berkshire Hathaway Annual Report, 1997) With only these three funds in your investment portfolio you can benefit from low costs and broad diversification and still have a portfolio that is easy to manage. You don’t need 10 or more holdings to be diversified when these three best buys should do it.

Monkeys, what say you? Have your views on individual stock investing evolved over the years? Is the lure of active investing too great to resist? How many of you are index fund devotees?

 

Yep, you want some real assets in your portfolio.

A lot of brokerages will have portfolio builders that allow you to select funds to match your target allocation. $2 a trade adds up if you actively manage. I even use some of the free, no-commission ETFs that my brokerage offers, saving even more money.

There's a very small % of hedge funds and active investors that can beat the market. Capital preservation is irrelevant. It's more the fact that professionals suck at this, so an amateur will almost certainly fail.

 

Your last point is true but a small investor with $10mm (as an example) and a certain level of sophistication, education, inclination, time, etc. should have two things working in his favor: size and time horizon. Too many funds become asset gatherers constrained by the size of the capital base that they must deploy and are judged on a quarterly basis under the pressure of potential future redemptions. With $10mm I can seek to identify a few names per year (in a 10-20 stock portfolio) with the goal of looking for doubles over a multi-year time horizon. This value oriented approach limits transaction fees and expenses (as I am holding for at least 12 months unless something significant changes the thesis), taxes, and other frictional expenses. I do think people underestimate the level of stress and time required to manage your own PA.

 

Bingo.

There is another takeaway from 'A random walk..' and the economics the book is based on: you can get excess returns if you have better information than the rest of the market.

E.g. You have specialized knowledge of a company's industry, competition, performance factors and have an idea of how that will change over time. If that view is not the conventional wisdom, and you keep testing your assumptions, eventually the market will catch on and adjust valuation accordingly.

Realizing that information premium is not for the average investor.

 
Best Response

Yeah, I totally agree with this.

My father has spent his entire career in the pharmaceutical industry, and while he doesn't have much knowledge in the realm of finance, he's always made a killing on his portfolio. This is also in large part because he's willing to break a lot of rules. His active portfolio (not including retirement accounts such as 401k, IRA, etc) is over 50% pharmaceuticals. Hell, there was a time when almost 40% of his entire active holding portfolio was just Pfizer. He breaks a ton of rules, but he spends well below his means, so his logic is that its ok to take bigger risks with his investing.

I'd argue and tell him that what he's doing is breaking every single damn rule of investing, but at the end of the day, his results are impressive. Between his personal knowledge and the conversations that he has with others in the pharmaceutical industry, he is generally able to gauge whats going to work in the long run and what won't. And then he bets heavily on it. He's rarely been wrong about what companies are going to be winners and which ones are going to be donkeys. I'm certainly never going to be able to replicate his investing success (although that has as much to do with what year it is as anything else), despite the fact that he's basically a self-taught investor. I'm not sure whether to be humbled by his insight and success or worry that he might gamble it away on a hunch. I suppose its a bit of both.

 

This point has been made, but it's true that most mutual funds do not beat the market, and even the ones that do have trouble sustaining their success over a significant period of time. Indexing is your best bet, and given the diversified array of ETFs available today, you can much more easily take a bet a certain sector while making a play on the market as a whole. That being said, none of this will make you the next Jesse Livermore, but maybe that's a good thing.

 

I prefer Index annuities, as of my info or input for now, or a 30 year IRA. As described by World Financial Group. Not interested in stock, like you no experience. Have exsposure to bonds and funds.

Patricia Walls
 

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