an all-star investment portfolio that will build and protect your wealth over the years ahead.
Earlier in this chapter, we discuss the spectrum of available investments and highlight the important differences among them. Ownership investments, including stocks around the world, real estate, and small business, offer the greatest potential returns but also higher risk.
We don’t explicitly discuss real estate and small business in more detail in this section except to say that for asset allocation purposes, they can fulfill a role similar to investing in stocks. For a detailed discussion of real estate and small business investment opportunities, pick up a copy of the latest edition of Eric’s best-selling book, Investing For Dummies (Wiley).
In this section, we discuss core funds — such as funds of funds, target-date funds, index funds, and exchange-traded funds — that make sense for you to consider. We also present some methods for assessing and managing your investment portfolio.
Funds of funds and target-date funds
Most fund investors feel overwhelmed by having so many choices. They understand the need to hold a diversified portfolio, but they’re not sure how to assemble one. Enter funds of funds and target-date funds. Both of these types of funds give you exposure to numerous funds within a single fund. And target-date funds gradually adjust the risk of the portfolio as you approach a particular retirement date.
Examining funds of funds
Decades ago the mutual fund industry was beginning to reach critical mass and developing and expanding its fund offerings. The large fund companies soon had dozens of funds, and increasing numbers of investors found choosing among them overwhelming.
Informed individual investors understood the concept of diversification and knew they should invest in a variety of funds that gave them exposure to different types of assets. And fund company representatives often found themselves being asked by investors for advice about what basket of funds they should invest in. So fund companies created funds of funds — that is, single funds comprising numerous companies’ funds.
For example, consider the Vanguard Star fund, which was created in 1985. It’s made up of ten Vanguard funds, including domestic and foreign stock funds, bond funds, and a money market fund. Stocks comprise about 62.5 percent of the fund (and about 30 percent of those are foreign), bonds about 25 percent, and money market assets about 12.5 percent. Of course, one size doesn’t fit all, but for investors seeking global diversification and an asset allocation similar to this fund’s, Star offers low costs (its annual operating expense ratio is just 0.31 percent) and relatively low minimum investment amounts ($1,000).
Understanding target-date funds
Target-date funds are funds of funds with a twist. Rather than maintaining a generally fixed asset allocation, especially between stocks and bonds, target-date funds adjust their mix over time.
For example, the T. Rowe Price Retirement 2040 Fund is designed for investors expecting to retire around the year 2040. It invests in about 22 different T. Rowe Price stock and bond funds. Over time (and as you approach the retirement date of 2040), the fund reduces its stock exposure and increases its bond exposure. Thus, it reduces the riskiness of the portfolio.
The risks of target-date funds are similar to funds of funds. The only additional risk of a target-date fund is if the fund manager tries to time the markets in his moves into and out of stocks and bonds and guesses wrong. The funds we recommend in this chapter don’t suffer this flaw.
Fidelity Freedom funds (www.fidelity.com)
T. Rowe Price Retirement funds (https://individual.troweprice.com/public/retail)
Vanguard Target Retirement funds (www.vanguard.com)
Index and exchange-traded funds
A simple, low-cost way to invest in stocks or bonds is to invest in what’s known as an index fund. These are passively managed funds that mechanically follow an index, such as one of the following:
Bloomberg Barclays U.S. Aggregate Bond Index: A broad index that tracks the U.S. bond market.
Standard & Poor’s (S&P) 500 Index: Tracks 500 large U.S.-headquartered-companies’ stocks.
MSCI U.S. Broad Market Index: This index follows small, medium, and large U.S.-company stocks.
MSCI Europe Index, MSCI Pacific Index, MSCI Emerging Market Index: These three indexes respectively track the major stock markets in Europe, the Pacific Rim, and in emerging economies, such as Brazil, China, India, and so on.
FTSE All-World Index: A global stock market index.
Some have higher expenses than others. Lower costs, of course, are generally better when comparing index funds that track the same index (as long as the lower-cost index fund tracks its index well).
Some indexes are likely to produce better long-term returns than others. For example, we have some concerns about the S&P 500 index because it’s a capitalization-weighted index. With this type of index, stocks hold a weighting in the index based on their total market value.For instance, during the 1990s, the technology sector’s stock weighting in the S&P 500 index ballooned from about 6 percent in 1990 to 29 percent by 1999. So investors buying into an S&P 500 at the end of 1999 had nearly 30 percent of their investment dollars going into pricey technology stocks. The financial sector experienced a similar ballooning in weighting before its steep price drop in the late 2000s.
In addition to traditional index funds, some index funds invest in value-oriented stocks, which are those selling at relatively low valuations compared to the companies’ financial positions. Value-oriented stocks are far less likely to hold hot sector stocks destined to crash back to Earth. You also can use index funds that invest in equal weights in the stocks of a given index.
Exchange-traded funds (ETFs) are index-like funds that trade on a major stock exchange. The best ETFs have even lower costs than index funds. But plenty of ETFs have
